Quantifying risks and putting a risk management system in place are the bedrock of investments. However, while the risk assessment tools for traditional investments are reasonably mature, incorporating climate risks into investments is relatively new, and the tools for climate risk assessments are evolving. In this article, we explore three tools developed to quantify climate-related risks. These are Climate Value at Risk (CVaR), Climate Transition Value at Risk (CTVaR) and Physical Climate Value at Risk(PCVaR), all of which can be considered extensions of the more traditional risk metric – Value at Risk (VaR).
1. What is Value at Risk (VaR)?
Since VaR is a widely used risk measurement tool in the financial services industry, we only provide a definition to set the context for CVaR and CTVaR. According to the Corporate Finance Institute, “Value at Risk (VaR) is a financial metric that estimates the risk of an investment. More specifically, VaR is a statistical technique used to measure the amount of potential loss that could happen in an investment portfolio over a specified period of time. Value at Risk gives the probability of losing more than a given amount in a given portfolio.”
There are similar definitions from other sources, but at its core, VaR has three elements.
- Specified amount of loss in value or percentage
- Time period over which the risk is assessed
- Confidence interval
- What is Climate Value at Risk (CVaR)?
CVaR was developed by Carbon Delta(now part of MSCI), and the concept of CVaR was explained in detail in a 2019 report published by UNEP Finance Initiative. This report presented the work of twenty institutional investors who worked together to “analyze, evaluate, and test, state of-the-art methodologies to enable 1.5°C, 2°C, and 3°C scenario-based analysis of their portfolios in line with the recommendations of the FSB’s Task Force on Climate-related Financial Disclosures (TCFD).”
According to the report, the CVaR metric is used to assess the impact of climate change-related risks and opportunities on an asset’s market value, under a specified climate scenario over a 15-year time horizon. This is done across the two pillars of climate risks – physical risks and transition risks.
According to the Bank of International Settlements, physical risks are the economic costs and financial losses resulting from the increasing severity and frequency of climate change related events. Transition risks on the other hand are the risks related to the process of adjustment towards a low-carbon economy. Physical risks include acute and chronic risks while transition risks include policy and legal risks, technology risks, market risks and reputational risks.
The use of CVaR is not restricted to just an asset, but to assess the market value of companies, securities (debt and equity), real estate assets and portfolios. The formulae for calculating the specific CVaRs are given below.
CVaR(Enterprise) = Present Value of climate costs or profits/Market value of enterprise
CVaR(Equity) = (equity climate costs/profits)/market value of equity
CVaR(Debt) = (debt climate costs/profits)/market value of debt
At a portfolio level, the risk is estimated by considering the portfolio companies’ assets, their locations and the traded securities, and aggregated upwards.
The full report can be accessed here.
- What is Climate Transition Value at Risk (CTVaR)?
CTVaR takes the concept of CVaR one step further, and focuses on the “transition risks”, which is one of two pillars of climate risks. Promoted by Willis Towers Watson(WTW), and by Institutional Shareholder Services(ISS), CTVaR measures the expected change in today’s prices of assets as a result of the transition to the net zero economy which are caused by policy, regulation, technology and customer preferences.
According to WTW, the estimation of CTVaR is similar to CVaR in the sense the effect of climate on individual companies are estimated and aggregated at the portfolio level.
CTVaR offers a bottom-up granular approach to measuring the effect that changes to the global economy (driven by climate change mitigation) will have on a company’s valuation. Read more about CTVaR from WTW here and ISS here.
4. What is Physical Climate Value at Risk(PCVaR)?
Physical Risks form the second pillar of climate risks. According to ISS, it is important for investors to estimate a portfolio’s exposure to climate risks(which include acute and chronic risks), and the drivers of these risks. These drivers include a company’s geographical footprint and the nature of business activity. ISS explains how “asset intensity”(total value of property used to generate a certain amount of revenue) can influence the VaR of an asset. Analysis of this nature help in estimating the Physical Climate at Risk of an asset or portfolio. The ISS article on the topic can be accessed here.
Conclusion
As climate risk assessment and management becomes increasingly important, new tools like CVaR, CTVaR and PCVaR will be extensively used and refined.
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