Taming the Green Swan: a criteria-based analysis to improve the understanding of climate-related financial risk assessment tools

Abstract

ABSTRACT Understanding climate-related risks has become a key priority in financial decision-making and for regulatory supervision in the financial sector since the Task-force on Climate-related Financial Disclosures (TCFD) launched its recommendations on climate risk disclosures in 2017. However, a systematic approach to identify scientifically sound and decision-useful climate risk indicators and the tools to derive such risk metrics is still missing. Focusing on climate-related financial transition risks, we propose a set of analysis criteria rooted in climate science, economics, finance, and risk management, to assess whether climate transition risk analysis tools provide high quality, comparable, and decision-relevant results. We find that for a sample of 16 climate transition risk tools, some tools perform high on all criteria, but that especially model transparency, scenario flexibility, output-related uncertainties, and assumptions communication require considerable improvements. Financial supervisors and regulators should define appropriate ways to obtain comparable climate risk metrics, to ensure their interpretability, and to ensure that climate risk metric disclosures reflect the underlying assumptions and uncertainties surrounding the analyses. Researchers and any user of climate risk metrics should carefully understand and report the analysis tools’ setup, and interpret their findings in light of the analysis assumptions. Key policy insights Providers of climate risk analysis tools should increase transparency on the tools’ setup in standardized templates. Reporting templates should include information on whether the tool has been peer-reviewed, the depth of risk analysis, key modelling steps and underlying assumptions. Firms should report the tool setup and modelling assumptions in their voluntary climate-related disclosures. In addition, uncertainties surrounding the analysis should be reported, for example, via confidence intervals or probability distributions. Financial regulators and corporate reporting regulation should ensure that mandatory climate risk disclosures are understandable and comparable. Regulators should ask firms to disclose their risks based on harmonized climate risk metrics disclosure templates, to ensure that key assumptions, the model setup, limitations of the analyses and analysis uncertainties are reported alongside the metrics.