CLIMAFIN Handbook: Pricing Forward-Looking Climate Risks Under Uncertainty

Abstract

Aligning finance to sustainability requires methodologies to price forward-looking climate risks and opportunities in financial contracts and in investors' portfolios. Traditional approaches to financial pricing models cannot incorporate the nature of climate risk (i.e. deep uncertainty, non-linearity and endogeneity), and of financial risks (interconnectedness and complexity). To fill this gap, we developed a transparent, science-based framework to assess and price climate financial risks under uncertainty, the CLIMAFIN tool. It embeds climate scenarios adjusted financial pricing models (for equity holdings, sovereign and corporate bonds), climate scenarios conditioned risk metrics (such as the Climate Spread and the Climate Value-at-Risk). These allow us to introduce forward-looking climate risk scenarios in the valuation of counterparty risk, in the probability of default and largest losses on investors' portfolios. This handbook is intended to support investors in the assessment of forward-looking climate risks in their portfolios and in the identification of portfolios' risk management strategies, and financial supervisors in the analysis of risk exposures that could have implications for systemic risk and in the design of prudential measures to mitigate such risk.