Transition Risk Models for Loan Portfolio Stress Testing
Dr Rui Qin, Ashwani Roy, Dr Arpad Borock · 2024-06-10
Climate transition risk is the financial stress a company faces as the economy decarbonises, and it reaches a bank through its borrowers. This paper sets out two methodologies for quantifying that stress on a loan portfolio, both aligned to NGFS climate scenarios and to the approaches proposed by the Central Bank of the UAE and the Bank of Canada. It covers the full chain from emissions data to probability of default.
Main contributions
- Transmission channels identified through which transition risk reaches a borrower: carbon prices compressing EBITDA, market share lost to changing client preferences, capital outlay for greener technology without matching revenue, and assets stranded by regulatory change.
- A top-down market shock approach, modelling the change in market share of firms within a sector and geography and translating it into the valuation of the loan portfolio.
- A bottom-up carbon cost approach, applying scenario-dependent carbon prices to company emissions, flowing the cost through EBITDA to total asset value, and converting the asset value shock into probability of default.
- Cluster analysis for data gaps, using K-means with cosine distances and K-nearest neighbours to calibrate greenhouse gas emissions for companies that do not report them, with a carbon multiplier derived by region, sector and time.
- Parameter uncertainty examined directly, alongside the four NGFS pathways covering current policies, net zero 2050, delayed transition and immediate transition.
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