Guide for CROs and Heads of Investment
The most pressing issue for CROs and Heads of Sustainability is where to start. The messaging around the need for the industry to respond in a sustainable and responsible way to the challenges are now completely understood. The challenge is how to switch rhetoric at the macro level to risk measurement at the micro, corporate level.
We have released our papers on the challenges of modelling climate risk and what to look for in effective model:
The landscape for climate change is evolving rapidly, with large vendors muscling in and buying out some of the smaller players. By adjusting their existing credit models and declaring they have a credit model misses the granularity any risk model has to achieve in order to be remotely useful.
The view at Quant Foundry is that in order to have a useful and differentiating model (i.e. do I invest in BP or Shell over the next five years?), the following features are essential:-
- Coherent macroeconomic model. The model needs to create a narrative that links the policy around climate (e.g. net-zero by 2050) to the interlinked areas of economic activity such energy, oil and gas, transport, heavy industries as well as agriculture. The model then needs to reflect this coherent view of how they all work together onto a list of expectations and constraints such as efficiency gains, emissions allowance, transition pathways, land use and levers such as carbon tax
- A microeconomic model that talks to risk professionals. The model needs to measure in a neutral and scientific way the impact of the expectations and constraints has on individual companies as the transition to the new economic paradigm. The model needs to provide sufficient insight to an officer to make risk (and not CSR) driven decisions
- Traceable combination of the macro and the micro. The macroeconomic model needs to work in step with the microeconomic model so that the results have a clear risk context and that the two models provide transparency for the risk decision-maker and that the combined models provide traceability back to the relevant policy or regulator scenario
- Capture rationale corporate behaviour. The combination of the two models needs to facilitate the conversation between a corporate or a structured project and the credit officer. The latter needs a credit model that provides insight on drivers of the climate change premium that includes the optimised corporate strategy to complete the transition
- Don’t forget Physical Risk. IAMs are designed so that the cost of transition is higher than inaction. Losses from increased severity and frequency of climate-related hazards are needed to provide a balanced view of which corporate assets are particularly exposed to damage and disruption.
- Future-proof. Time is now short for financial firms to build their own solution. The fragmentation of data providers, the demands on data normalisation, the temptation to go with a basic top-down model will not get an organisation past TCFD
Quant Foundry has from the outset built the Climate Change Corporate Credit Model (QF4CM) from the bottom-up so that financial firms can accelerate their development and deployment so that they can respond to regulatory requests for disclosure and stress testing. The cost of developing own solution is prohibitive and will take multiple years to implement.
With the best will, financial firms need to stay in-step with the wider discussions around climate change and their role in addressing these challenges.
QF4CM, integrated with Imperial’s world-class IAM provides the neutrality and rich suite of risk measurement to enable firms to build a coherent narrative around their response to climate-related risk.
QF4CM has also integrated physical risk from well know physical risk provider so that the credit quality of a corporate shift based on expected impacts to revenue and the bottom line due to climate hazards.