The modelling of climate-related financial risk

Sergio Scandizzo and Tony Hughes

INTRODUCTION

The discussion carried out in Part 1 has outlined a number of issues that are routinely overlooked in the supervisors’ approach to climate-related financial risk. One-sided hypotheses in asset valuation, undocumented assumptions on the banking system’s resilience and almost exclusive use of scenario analysis as a means to assess the financial impact are features so common in the current discourse that we have almost stopped noticing them. It is worthwhile then, before looking at the available modelling methodologies, to examine more closely where the prevailing approach comes from and the fundamental relationship between risk assessment and policy objectives.

The recognition of the importance of climate-related financial risks by central banks and financial supervisors has led to the formation of the Network for Greening the Financial System (NGFS) to address these risks. Dealing with physical, transition and liability risks is an emerging concern, and there are challenges in measuring and forecasting them to support effective financial policy interventions. The regulatory response to these challenges has been extensive so far but broadly in line with the prudential