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Assessing Climate-Related Financial Risk: Guide to Implementation of Methods

Author

Listed:
  • Hossein Hosseini
  • Craig Johnston
  • Craig Logan
  • Miguel Molico
  • Xiangjin Shen
  • Marie-Christine Tremblay

Abstract

The Bank of Canada and the Office of the Superintendent of Financial Institutions completed a climate scenario analysis pilot project with the collaboration of six Canadian financial institutions. The project aimed to increase understanding of the financial sector’s potential exposure to risks in transitioning to a low-carbon economy and to help build the capabilities of authorities and financial institutions in assessing climate-related risks. To support the broader financial-sector community in building these capabilities, this report provides detail on the methodologies the pilot used to assess credit and market risks, which were informed by the financial impacts generated by the climate transition scenarios. The method to assess credit risk combined top-down and bottom-up approaches. Variables from the climate transition scenarios were first translated into sector-level financial impacts. The financial institutions then used these impacts to estimate the implications on credit outcomes through borrower-level assessments. Using the transition scenarios’ financial impacts, and the stressed credit outcomes, the project estimated a relationship between climate transition information and credit risk. This was used to calculate expected credit losses at the portfolio level. The method to assess market risk was solely top-down. Using the scenario analysis, the project used a dividend discount model to estimate sectoral equity revaluations, which it then applied to equity portfolio holdings.

Suggested Citation

  • Hossein Hosseini & Craig Johnston & Craig Logan & Miguel Molico & Xiangjin Shen & Marie-Christine Tremblay, 2022. "Assessing Climate-Related Financial Risk: Guide to Implementation of Methods," Technical Reports 120, Bank of Canada.
    • Handle: RePEc:bca:bocatr:120
    DOI: 10.34989/tr-120
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    References listed on IDEAS

    as
    1. Y.-H. Henry Chen & Erik Ens & Olivier Gervais & Hossein Hosseini & Craig Johnston & Serdar Kabaca & Miguel Molico & Sergey Paltsev & Alex Proulx & Argyn Toktamyssov, 2022. "Transition Scenarios for Analyzing Climate-Related Financial Risk," Discussion Papers 2022-1, Bank of Canada.
    2. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
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    Cited by:

    1. Ojea-Ferreiro, Javier & Reboredo, Juan C. & Ugolini, Andrea, 2024. "Systemic risk effects of climate transition on financial stability," International Review of Financial Analysis, Elsevier, vol. 96(PB).
    2. Bruneau, Gabriel & Ojea-Ferreiro, Javier & Plummer, Andrew & Tremblay, Marie-Christine & Witts, Aidan, 2025. "The interdependencies of Canadian financial institutions: An application to climate transition shocks," Latin American Journal of Central Banking (previously Monetaria), Elsevier, vol. 6(3).
    3. Gabriel Bruneau & Javier Ojea Ferreiro & Andrew Plummer & Marie-Christine Tremblay & Aidan Witts, 2023. "Understanding the Systemic Implications of Climate Transition Risk: Applying a Framework Using Canadian Financial System Data," Discussion Papers 2023-32, Bank of Canada.
    4. Anna Burova & Elena Deryugina & Nadezhda Ivanova & Maxim Morozov & Natalia Turdyeva, 2023. "Transmission to a low-carbon economy and its implications for financial stability in Russia," Bank of Russia Working Paper Series wps109, Bank of Russia.

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    Keywords

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    JEL classification:

    • C - Mathematical and Quantitative Methods
    • C5 - Mathematical and Quantitative Methods - - Econometric Modeling
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • C83 - Mathematical and Quantitative Methods - - Data Collection and Data Estimation Methodology; Computer Programs - - - Survey Methods; Sampling Methods
    • G - Financial Economics
    • G1 - Financial Economics - - General Financial Markets
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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