Climate Risk Stress Testing

A Presentation to the American Bankers Association July 15, 2021

Meeting with you today

Simon Fisher Michael Monaco

Partner Senior Manager
[email protected] [email protected]

Background Background

• Partner in Deloitte’s Model Risk Management team • Senior Manager in Deloitte’s Model Risk Management team
• 20+ years of experience providing services to financial • 10 years of experience with risk and modeling in the
services organizations financial services industry
• Focuses on risk management policies, procedures, • Focuses on developing and validating models used for
model validation and governance credit, market, and operational risk
• Co-leader of Deloitte’s US Climate Risk team • Member of Deloitte’s US Climate Risk team

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 2
Climate Risk Stress Testing
A Presentation for Model Risk Managers

Presentation Agenda

Topic Slides
Objectives
1 Climate Risk in Context 4
2 Regulatory and Industry Trends 5-7
3 Climate Risk Dynamics 8 Gain an introductory understanding of climate
risk management at financial institutions
4 Modeling Climate Risk 9
5 Climate Risk Stress Testing 10
Understand processes and methodologies used
a Global Regulatory Perspectives 11 for climate risk stress testing

b Climate Data 12
c Scenario Development 13 Understand key climate risk challenges &
solutions for risk managers
d Impact Analysis 14
6 Considerations for Risk Modelers 15
7 Climate Enterprise Risk Management 16
8 Q&A 17

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 3
Climate Risk in Context
The Environment, Social, and Governance Landscape
Environment, Social, and Governance (ESG) themes in aggregate translate into a broad range of risks to financial institutions. These
risks are often interdependent, latent, and difficult to quantify.

De-
forestation Social
Access to Inequality
natural Gender
resources Inequality “For the first time in
the history of the
survey, climate-related
Population
Rising Climate Risk Migration
sea levels
issues dominated all of
the top-five long-term
Physical Transition
risks risks risks by likelihood…”
Investor
Natural
disasters
Pressure The Global Risks
Report 2020, World Economic
Access to New Forum
water Failure to taxation
Increased
or new comply /
Key: ESG risks litigation adapt

Environment

Social

Governance

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 4
Regulatory & Industry Trends in Climate Risk
US Regulation (2019-2020)
A variety of US regulatory bodies begin to establish perspectives and adopt policies around managing climate risk.
Sep 2020
Mar 2019
New York State Department of Financial Dec 2020
San Francisco Federal Reserve Board May 2020
Services (NYDFS) expects Insurers to begin FRB Governor Lael Brainard
(FRB) publishes economic letter on SEC’s Investor Advisory
Nov 2019 integrating climate-related risks into delivers speech on climate
monetary policy implications of Committee approves a policy governance frameworks, risk management change related challenges of
climate risk. FRB hosts first-ever climate risk document related to ESG processes, and business strategies. the financial system titled
conference, ”The Economics of disclosure.
CFTC’s Climate-Related Market Risk "Strengthening the Financial
Climate Change” to discuss
Subcommittee publishes report on impacts System to Meet the Challenge
quantifying the impact of climate
of climate risk to US financial markets. of Climate Change."
change in the financial sector.

2019 2020

Monthly climate July 2020 Dec 2020

risk regulatory
developments in San Francisco FRB launches virtual FRB announces that it has formally
FSI Link July 2019 seminar series on the economics of joined the Network of Central Banks
climate change, including monetary, and Supervisors for Greening the
Commodity Futures and
supervisory, and trade policy. Financial System (NGFS).
Trading Commission (CFTC)
establishes Climate-Related Jan 2020
Market Risk Subcommittee. Oct 2020
Securities and Exchange Commission
(SEC) issues public statement on NYDFS expands efforts to ensure
“Modernizing Regulation S-K: Ignoring financial services firms manage their
the Elephant in the Room.” financial risks from climate change.
Legend
Voluntary organization/initiative

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 5
Regulatory & Industry Trends in Climate Risk
US Regulation (2021)
Regulatory activity is accelerating, and although formalized policies have been limited, additional guidelines are expected to emerge.
Jan 2021 Jan 2021 May 2021
Mar 2021
FRB creates a new leadership SEC appoints a new senior policy advisor for Biden signs
Feb 2021 The SEC’s Division of Examinations executive order
committee focused on supervising Climate and ESG to oversee and coordinate the
announces its 2021 examination which provides a
the banking system for financial agency’s efforts related to climate risk and other FRB Governor Lael Brainard endorses priorities, including plans to focus on framework for US
risks posed by climate change. ESG developments, which are “issues of great mandatory climate risk disclosures for climate risks “by examining proxy voting agencies and
significance to investors and the capital markets.” public companies and encourages climate- policies and practices to ensure voting regulators to adopt
related scenario analysis as a helpful but aligns with investors’ best interests and new climate risk
distinct approach from the Fed’s existing expectations. measures.
regulatory stress tests at banks.

2021

Monthly climate Mar 2021

risk regulatory
The SEC announces a newly created Apr 2021
developments in
FSI Link Jan 2021 Climate and ESG Task Force in the
Division of Enforcement to proactively The SEC issues a risk alert for ESG
Treasury Secretary Janet Yellen identify ESG-related misconduct using
proposes new efforts by the investing.
“sophisticated data analysis to mine
Treasury to address climate risks Feb 2021 and assess information across Secretary Yellen appoints new
in the financial system during her registrants, to identify potential Climate Counselor to oversee
The House Financial Services
Senate confirmation hearing. violations. Treasury's coordination on climate-
Subcommittee on Investor Protection
features ESG disclosure in its hearing, related financial risks across the
“Climate Change and Social US government and globally.
Responsibility: Helping Corporate
Boards and Investors Make Decisions
Copyright © 2021 Deloitte Development LLC. All rights reserved. for a Sustainable World.” DRAFT – For Discussion Purposes Only 6
Regulatory & Industry Trends in Climate Risk
A global ecosystem

International Initiatives Regulatory Authorities

Set standards for diverse set of climate topics including Network of global central banks and regional authorities
disclosures, regulation, and modeling methodologies establishing regulatory requirements for climate risk

Rating Agencies
Rating agencies incorporate climate into credit analysis

Data Providers
Research Institutes Vendors providing data on physical and transition risks, as
well as broader ESG metrics
Provide valuable climate science research, generating data
and developing scenarios in collaboration with regulators

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 7
Climate Risk Dynamics
Risk Transmission Channels

Physical and transition risks manifest as business risks via micro and macro economic transmission channels.

Climate Risks Transmission Channels Business Risks

Physical Risk Microeconomic Financial Risk
• Chronic (e.g., temperature changes, • Financial impact on individual • Credit
sea level rise) households and businesses
• Market

• Acute / catastrophic (e.g., • Business disruption • Liquidity

heatwaves, floods) • Operational
• Property damage & liabilities
Transition Risk Non-Financial Risk
• Policy & regulation (e.g., carbon tax) Macroeconomic
• Reputational
• Unemployment
• Strategic
• Technological development (e.g.,
electric vehicles) • GDP changes • Physical Security
• Model
• Consumer preferences • Capital depreciation
• Compliance & Regulatory

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 8
Measuring Climate Risk
Use Cases for Climate Models
A variety of qualitative and quantitative approaches exist to identify and measure the potential impacts of climate risk based on the use
case within an organization.

Use Cases for Climate Modeling Modeling Methodology Highlights

Stress Testing Discussed in subsequent slides

 Considers long-dated scenario narratives (i.e., 30-50 years)
Climate scenarios may be developed to assess impact on
 Focuses on credit risk, with some jurisdictions also considering market risk
business risk drivers for internal or regulatory stress testing

Disclosures  Consolidation of analysis across use cases (i.e., strategy & risk management)
Internal and external disclosures (e.g., TCFD) typically require
an analysis of climate risk impacts  To date, typically based on high level analysis without formal modeling approaches

Strategic Metrics & Targets  Prescriptive accounting standards (PCAF) for scope 1, 2, and 3 definitions
Sustainability commitments often include science-based targets
 Reliance on publicly disclosed emissions with extrapolation across sectors
related to Scope 1, 2, and 3 emissions

Credit Risk Management  Climate factors considered in underwriting for standalone ESG ratings or within
Analysis of climate risk is increasingly integrated into existing scoring framework
underwriting and credit portfolio management processes  Portfolio management focuses on PD impact via stress testing / scenario analysis

Other  Models used for investment portfolio to calculate metrics such as temperature
Other use cases include market risk, operational risk, and alignment and climate VaR
product strategy (e.g., asset management tools)
 Banks may perform scenario analysis to understand operational risk associated with
physical risk damage to key infrastructure
Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 9
Climate Stress Testing
Process Overview
Although specific practices for climate risk stress testing are yet to be prescribed by regulatory authorities in the US, some banking
institutions are preparing for stress testing by following the below steps:

Discussed in subsequent slides

Planning Data Scenario Impact

Outcomes
Gathering Development Analysis

Define objectives for Gather internal, Develop projections Analyze impact of Leverage output for
stress testing and public, and vendor- of climate metrics climate scenarios on regulatory
understand key risk based data to under pathways assets for key metrics reporting, strategic
exposures develop climate defined by scenario such as probability of decision making, and
scenarios and analyze narratives default public disclosures
impacts

Regulatory Requirements

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 10
Climate Stress Testing
Global Regulatory Perspectives Regulatory Requirements

The NGFS is helping promote alignment in global regulatory practices, but significant uncertainty remains around adoption in the US.
This is highlighted by comparing practices for the two jurisdictions to date with formalized requirements.

Comparison of Global Stress Testing Practices1

Jurisdictions with formalized requirements

Bank of England Banque de France

Participation • Large banks and insurers • Large banks and insurers

Timetable • Launches June 2021, results Q1 2022 • Launched July 2021, aggregate results May 2021

• 2050 (with add on for 2050-2080 risks under “No Policy

Forecasting Horizon • 2050
Action” scenario)

Balance Sheet • Static through 2050 • Static through 2025, dynamic from 2025-2050

• Physical and Transition Risks: Early, Late, and No Policy • Transition Risk: Orderly, Disorderly, and Immediate 1.5
Scenarios Action based on NGFS with additional macro variables based on NGFS with additional macro various provided
provided by BoE • Physical risk: Based on “RCP 8.5” IPCC scenario

• Credit Risk: Impairment charge • Credit Risk: Expected Credit Loss (ECL)
Reporting Metrics
• Market Risk: Excluded • Market Risk: Revaluation of trading portfolio

1. Source: GRI-Climate-Change-Article_012621.pdf (garp.org)

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 11
Climate Stress Testing
Gather Climate Data
A combination of internal data related to asset characteristics and external climate scenario data is needed to perform climate risk
stress testing.
Internal Data External Data

 Asset portfolio information needed to  Regional scenario projections for chronic

assess credit and market risk (typically and acute physical risk, e.g.:
loan portfolio data):  Mean temperature rise Physical
 Exposure ($) Risk
 Flood/rainfall discharge
 Geography
 Crop yields
 Industry/Sector
Asset  Heatwaves
Attributes  Loan Maturity
 Sector scenario projections for transition
 Qualitative factors (e.g., business
risks, e.g.:
strategy) Climate  Emissions price (e.g., carbon tax)
Transition
 Operational risk assessment may require Stress Testing  Carbon dioxide removal Risk
data on office locations, data centers, etc.
to measure physical risk  Investments in renewables
 Land usage
 Business-as-usual metrics such as  Additional macroeconomic variables
Expected Credit Loss may be used as provided by regulators to supplement
baseline against stress scenarios climate scenarios, e.g.:
Models & Macro-
Metrics  Existing models and their input data (e.g.,  GDP economic
risk rating scorecards) may be leveraged  Unemployment
for climate stress testing
 Property prices

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 12
Climate Stress Testing
Develop Scenarios
Organizational Med
involvement
:
Organizational
involvement
: Med
Scenario Expansion
Organizational Med
involvement
: Sector downscaling
Organizational
• Expand scenario to include relevant
: Low macro risk drivers
involvement Climate Metric Forecasts • Global narratives scaled to
Organizational • Leverage combination of statistical
involvement
: Low regional/sector level
Climate Science Models • Climate data leveraged to build out techniques and experienced judgment
• Available from data vendors
global scenario narratives
Scenario Narratives • General Circulation Models (GCM) • Potentially defined by US regulators
• Collaboration between climate Variable Expansion
and Catastrophe models for physical in the future
scientists and regulators
• Context for developing scenarios risks
• Scenarios customized based on US Market Scenarios
• Typically based on regulatory guidance but • Integrated Assessment Models (IAM) business needs and risks
can be tailored for transition risks
Global NGFS GHG Scenarios
Scenario Narratives IPCC Pathways*

* Intergovernmental Panel on Climate

Change (IPCC) open-source climate
trajectories

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 13
 Climate Stress Testing
Analyze Impact
The United Nations Environment Program Finance Initiative (UNEP FI)1 has developed a methodology for quantifying the impact of
transition risks on wholesale exposures using a combination of bottoms-up and top-down modeling approaches.

Bottom-Up Module Top-Down Module

1 Develop calibration points by calculating PD impact of climate scenarios 2 Extrapolate PD impact across portfolio by calibrating a modified
for a sample of borrowers across homogeneous segments Merton distance-to-default model
Climate credit
quality
Merton Model adjustment
Borrower characteristics
• Financials 1 𝑟𝑟
• Metrics (e.g., emissions, production) 𝑃𝑃𝑃𝑃𝑖𝑖 |𝑐𝑐 ∗ = Φ[Φ−1 𝑃𝑃𝑃𝑃𝑖𝑖,𝑇𝑇𝑇𝑇𝑇𝑇 − ⋅ �(𝑠𝑠𝑗𝑗,𝑘𝑘 ⋅ 𝑓𝑓𝑘𝑘𝑟𝑟 )]
• Qualitative factors (e.g., strategy) 𝛼𝛼𝑘𝑘
𝑟𝑟
Scenario Adjusted
Financials Business-as-usual Impact of climate
• Fuel Costs Rating Model
Scenarios

transition risk
• Carbon Price
• Energy demand Revenue Distribution of asset
Debt
Threshold
value of a borrower
Climate
Expenses Adjusted PD

Scenario-implied
Capital Expenditures Rating & PD

1. Source: https://www.unepfi.org/wordpress/wp-content/uploads/2018/04/EXTENDING-OUR-HORIZONS.pdf Original PD

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 14
Climate Risk Modeling
Considerations for Risk Modelers
There are a number of challenges related to the development and validation of climate models, but modeling professionals can plan
ahead to prepare for this work.

Climate Modeling Challenges Modeling Team Strategies Planning Considerations

• Limitation management processes Coordinate with internal stakeholders

Inherent model limitations due to long
• Benchmarking and assumptions testing to understand model inventory
time horizons and limited data
• Ongoing monitoring and recalibration pipeline

• Understanding of vendor landscape

Early reliance on vendors for data and • Existing processes for vendor validation
modeling • Additional due diligence for data quality
Begin training and development of
talent to prepare for climate model
validations

Extensive scope of climate impacts • Stakeholder agreement for model pipeline

across organization • Alignment of resourcing requirements
Gain an understanding of “climate
ecosystem” including vendors,
• Knowledge of range of industry practices regulators, and research institutes
Evolving practices around modeling
• Awareness of regulatory developments &
requirements and methodologies industry initiatives

• Training of existing resources Develop benchmark methodologies

Cross-disciplinary skill required for • Resource acquisition or rotational programs for priority use cases within your
model development and validation • Development of benchmark methodologies organization

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 15
Climate Enterprise Risk Management (ERM) Components
Management of financial and nonfinancial risks derived from climate risks require careful updates to the ERM framework; leading firms have
assessed key changes and requirements.

Governance and Policy​

Risk Operating Model, People

and Culture Risk Strategy and Appetite​

Risk Data and Systems Risk Assessment, Measurement

and Analytics

Portfolio and Capital

Management Monitoring and Reporting​

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 16
 Questions?

Copyright © 2021 Deloitte Development LLC. All rights reserved. DRAFT – For Discussion Purposes Only 17