Climate Risk (CRISK) Analysis presents climate-related risk measures for global financial firms. These measures are updated on a regular basis and the historical estimates can be plotted to see the changing performance of individual firms.

Following Jung et al. (2022), the climate stress testing procedure involves three steps. The first step is to measure the climate risk factor by using the stranded asset (SA) portfolio return as a proxy measure for transition risk. The stranded asset portfolio is developed by Litterman and composed of 30% long position in the energy ETF (XLE), 70% long position in the coal ETF (KOL), and a short position in the market. We use MSCI all-country world index (ACWI) as the market. An underperformance of SA portfolio can be interpreted as a rise in transition risk.

The second step is to estimate the time-varying climate betas of financial institutions using the DCB model. We model bank i’s stock return with two factors as:$$\begin{array}{}\text{(1)}& r_{it}={\beta }_{it}^{\mathrm{Mkt}}{\mathrm{MKT}}_t+{\beta }_{it}^{\mathrm{Climate}}{\mathrm{CF}}_t+{\epsilon }_{it}\end{array}$$where $r_{it}$ is the stock return of bank $i$, $\mathrm{MKT}$ is the market return, and $\mathrm{CF}$ is the climate risk factor, measured from the previous step. The loading on the first factor, ${\beta }_{it}^{\mathrm{Mkt}}$, is called market beta and the loading on the second factor, ${\beta }_{it}^{\mathrm{Climate}}$, is called climate beta. The betas are estimated dynamically, following the Dynamic Conditional Beta model of Engle.

The third step is to compute $\mathrm{CRISK}$. This step extends the $\mathrm{SRISK}$ methodology of Acharya et al. (2011), Acharya et al. (2012), and Brownlees and Engle (2017). The CRISK is defined as the expected capital shortfall conditional on the climate stress, and is calculated as:$$\begin{array}{}\text{(2)}& {\mathrm{CRISK}}_{it}=k{D}_{it}-\left(1-k\right)W_{it}\left(1-{\mathrm{LRMES}}_{it}\right)\end{array}$$$D$ denotes the bank’s book value of debt, $W$ denotes the market capitalization of the bank, and $\mathrm{LRMES}$ denotes the Long-Run Marginal Expected Shortfall, which is the expected fractional loss of the firm equity when the $\mathrm{SA}$ portfolio declines significantly in a six-month period. It is calculated as:$$\begin{array}{}\text{(3)}& \mathrm{LRMES}=1-\exp \left({\beta }^{\mathrm{Climate}}\log \left(1-\theta \right)\right)\end{array}$$where $\theta$ is the climate stress level and its default value is 50%. k is a prudential level of capital as a share of assets.

Users may select values for the following options and see the effect on CRISK:

• Climate stress level ($\theta$): We define a systemic climate crisis as occurring when the SA portfolio falls by more than the crisis threshold in a six-month period. The default crisis threshold is 50%. The default choice corresponds to the 1% quantile of the SA return distribution, which can be considered an extreme scenario.
• Prudential Capital Requirement ($k$): The prudential capital requirement is the amount of capital, expressed as a share of assets, that a firm would need to weather a stress. Typically, well managed large financial institutions in normal times maintain a capital ratio of 8% for firms in Africa, Asia and Americas and 5.5% for firms in Europe. Users may change the prudential capital requirements by adjusting the k values.
• Market stress level: Users can also select a non-zero market stress level to test for a scenario in which a market stress comes together with a climate stress.

Marginal CRISK

Marginal $\mathrm{CRISK}$ is the difference between $\mathrm{CRISK}$ (with the currently selected climate stress) and non-stressed $\mathrm{CRISK}$, where the non-stressed $\mathrm{CRISK}$ is a capital shortfall under zero climate stress scenario. It measures the effect of climate stress after taking out the current capital shortfall. It can be expressed as:$$\begin{array}{}\text{(4)}& \mathrm{Marginal\; CRISK}=\left(1-k\right)W\mathrm{LRMES}\end{array}$$

CRISK Decomposition

CRISK can be decomposed into three components:$$\begin{array}{}\text{(5)}& \Delta \mathrm{CRISK}=k\Delta D-\left(1-k\right)\left(1-\mathrm{LRMES}\right)\Delta W+\left(1-k\right)W\Delta \mathrm{LRMES}\end{array}$$

• $d\mathrm{DEBT}=k\Delta D$ is the contribution of firm’s debt to $\mathrm{CRISK}$.
• $d\mathrm{EQUITY}=-\left(1-k\right)\left(1-\mathrm{LRMES}\right)\Delta W$ is the effect of firm’s equity position on $\mathrm{CRISK}$.
• $d\mathrm{RISK}=\left(1-k\right)W\Delta \mathrm{LRMES}$ is the contribution of increase in volatility or correlation to $\mathrm{CRISK}$. It reflects the changes in climate beta.