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OECD Workshop “Climate transition scenarios: integrating models into risk assessment under uncertainty and the cost of delayed action” (6 July 2022) - Sessions 2 & 3, Irene Monasterolo, EDHEC Business School, ERCII

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OECD Workshop on Climate
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Irene Monasterolo, Professor of Climate Finance, EDHEC and EDHEC-
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Assessing carbon stranded assets: lessons learned
1. Stranded assets not well defined yet: typically research focuses on...

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Battiston, S, ea (2017): A climate stress-test of the financial
system. Nature Climate Change
• Climate Policy Relevant ...

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OECD Workshop “Climate transition scenarios: integrating models into risk assessment under uncertainty and the cost of delayed action” (6 July 2022) - Sessions 2 & 3, Irene Monasterolo, EDHEC Business School, ERCII

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Presentation from the OECD Workshop “Climate transition scenarios: integrating models into risk assessment under uncertainty and the cost of delayed action” (6 July 2022) - Sessions 2 & 3, Irene Monasterolo, EDHEC Business School, ERCII

Presentation from the OECD Workshop “Climate transition scenarios: integrating models into risk assessment under uncertainty and the cost of delayed action” (6 July 2022) - Sessions 2 & 3, Irene Monasterolo, EDHEC Business School, ERCII

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OECD Workshop “Climate transition scenarios: integrating models into risk assessment under uncertainty and the cost of delayed action” (6 July 2022) - Sessions 2 & 3, Irene Monasterolo, EDHEC Business School, ERCII

  1. 1. OECD Workshop on Climate Transition Scenarios 2022 Irene Monasterolo, Professor of Climate Finance, EDHEC and EDHEC- Risk Climate Impact Institute (ERCIII) irene.monasterolo@edhec.edu Monasterolo_OECD_climate_transition_2022 1
  2. 2. 2 Assessing carbon stranded assets: lessons learned 1. Stranded assets not well defined yet: typically research focuses on fossil fuels reserves and production plants, and specific sectors (e.g. NACE B, C) 2. Beyond sectors: chain of directly/indirectly affected activities (e.g. combustion engines), and firms with mixed business lines (green coexisting with high-carbon) matter. This is why we developed the Climate Policy Relevant Sectors in 2017 3. Exposure is not financial risk: we need to consider investor’s leverage, adjustment in default probability, mispricing, interconnectedness 4. Focus on the assets that matter: bonds, loans (role in investors’ portfolios and balance sheet). Challenging (e.g. consider default correlation) 5. Climate stress test: from forward-looking distribution of losses, financial valuation adjustments, financial contagion model (interbank), conditioned to scenarios Monasterolo_OECD_climate_transition_2022
  3. 3. 3 Battiston, S, ea (2017): A climate stress-test of the financial system. Nature Climate Change • Climate Policy Relevant Sectors (CPRS): a classification of economic activities in transition risk categories to quantify stranded assets (Fig. 1) • CPRS consider activity’s (i) role in energy value chain, (ii) revenue, business model (input substitutability) (iii) cost sensitivity to policy (ministries, lobbies), (iv) GHG • We map NACE 4 digit codes in CPRS considering different levels of granularity (CPRS1, 2, granular) • Why CPRS? Because GHG emissions and carbon intensity misleading (Scope 1, 3) Fossil-fuel U,li,es Energy- intensive Housing Transport B C D F H NACE2 codes Climate-sensi,ve sectors Asset PorBol by instrumen Equity Bonds Loans Reclassifica,on of economic sectors from NACE2 into climate-sensi,ve sectors Classifica,on instrument a sectors Fossil-fuel U,li,es Energy- intensive Housing Transport B C D F H NACE2 codes Climate-sensi,ve sectors Asset PorBolio by instrument Equity Bonds Loans Reclassifica,on of economic sectors from NACE2 into climate-sensi,ve sectors Classifica,on of instrument and c sectors Fig 1: mapping economic activities into Climate Policy Relevant Sectors to assign a transition risk profile to a portfolio of contracts: Battiston ea (2017) Climate transition risk exposure: Climate Policy Relevant Sectors (CPRS) Monasterolo_OECD_climate_transition_2022
  4. 4. 4 Investors’ exposure to Climate Policy Relevant Sectors is high even after Paris Fig. 2: Percentage composition of portfolio of syndicated loans of major U.S. banks by climate-policy-relevant sector. Source: CERES 2020 CPRS exposure of US banks’ loans (2020) • JRC study of EU Taxonomy financial impact (Alessi ea 2019) • ECB Financial Stability Review 2019, 2020 • EIOPA’s Financial Stability Review 2019 • EBA Risk assessment of the EU banking system, Dec. 2020 • ESMA Advice to European Commission under Article 8 of the Taxonomy Regulation (2020) • National Bank of Austria, Financial Stability Report 2020 • Banco de Mexico 2021, J.Fin. Stab. • International Association of Insurance Supervisors (2021) • ECB/ESRB: Climate-related risk and financial stability (2021) Monasterolo_OECD_climate_transition_2022
  5. 5. Asset level risk assessment: CPRS-Granular Page 5 Monasterolo_OECD_climate_transition_2022 • CPRS-Granular integrates info about energy tech of plants owned by the firm, considering business lines and contribution to revenues. This info is associated to the financial contracts for adjustments in financial valuation and risk metrics. • Why this matters? Because firms’ plants may differ by technology thus being positively/negatively affected in the transition. Firm level info would average losses CPRS Main CPRS-2 CPRS Granular 3-energy-intensive 3-energy-intensive energy-intensive 3-energy-intensive 3-energy-intensive energy-intensive|cement 3-energy-intensive 3-energy-intensive energy-intensive|electrical 3-energy-intensive 3-energy-intensive energy-intensive|fertilisers and agrochemicals 3-energy-intensive 3-energy-intensive energy-intensive|iron and steel 3-energy-intensive 3-energy-intensive energy-intensive|non-fossil mining 3-energy-intensive 3-energy-intensive energy-intensive|other 3-energy-intensive 3-energy-intensive energy-intensive|pharmaceutical 3-energy-intensive 3-energy-intensive energy-intensive|rubber and plastics Source: Battiston et al. (2022)
  6. 6. Bridging asset level risk into climate scenarios 6 • CPRS-Granular allows us to assign a transition risk profile to IAM variables, and to map NACE 4-digit codes to relevant IAM trajectories across climate scenarios NACE CPRS1 CPRS2 CPRS-Granular NGFS_Granular 45.11 5-transportation 5-transportation|roads transportation|vehicles|combustion Final Energy|Transportation|Liquids 45.11 5-transportation 5-transportation|roads transportation|vehicles|electric Final Energy|Transportation|Electricity 45.11 5-transportation 5-transportation|roads transportation|vehicles|hybrid Final Energy|Transportation|Electricity 45.11 5-transportation 5-transportation|roads transportation|vehicles|hydrogen Final Energy|Transportation|Hydrogen 46.71 1-fossil-fuel 1-fossil-fuel fuel|fossil|sale Primary Energy|Fossil 47.30 1-fossil-fuel 1-fossil-fuel fuel|fossil|oil|sale Final Energy|Transportation|Liquids 49.10 5-transportation 5-transportation|railways transportation|infrastructure|land|railways|fossil Energy Service|Transportation|Passenger|Railways 49.10 5-transportation 5-transportation|railways transportation|infrastructure|land|railways|electric Energy Service|Transportation|Passenger|Railways 49.20 5-transportation 5-transportation|railways transportation|infrastructure|land|railways|fossil Energy Service|Transportation|Freight|Railways 49.20 5-transportation 5-transportation|railways transportation|infrastructure|land|railways|electric Energy Service|Transportation|Freight|Railways Monasterolo_OECD_climate_transition_2022 Source: Battiston et al. (2022)
  7. 7. • In the climate stress tests (Battiston et al. 2017), we translated trajectories of Integrated Assessment Models (IAM) across scenarios into financial valuation adjustment, individual and systemic risk in interbank network model (ECB data) • Banks with high-carbon investment strategy will face larger losses (Climate VaR, Fig.3) conditioned to climate scenarios. Adding contagion (light) polarizes losses. Investors’ leverage and interconnectedness Fig. 3: Value at Risk (5% significance) on equity holdings of 20 most affected EU banks under scenario of green (brown) investment strategy. Dark/light colors: first/second round losses.Source: Battiston ea (2017) Monasterolo_OECD_climate_transition_2022 7
  8. 8. Application: climate-aware portfolio rebalancing • ECB to include climate change considerations into its monetary policy framework • How? It will decarbonize its corporate bonds portfolio by tilting (i.e. increasing) the share of holdings in firms with better climate performance • Issuers’ climate performance measured by lower GHG emissions (backward looking) ambitious carbon reduction targets (forward-looking) • Challenges: • GHG emission data are not yet adequate to support portfolio rebalancing: scarce, inconsistent reporting, see scope 3 in Figure 4 • Scope 1 and 2: most data are estimates by data provides (different models) Fig. 4: Selected companies in transport and electricity generation. Differences in reporting for scope 1+2+3 emission intensity against fundamentals (e.g. renewable capacity, fleet emissions) that should be related to those intensities. Source: Bressan et al. 2022 Monasterolo_OECD_climate_transition_2022 8
  9. 9. An enhanced greenness measure for tilting • We developed an enhanced measure of greenness to account for limitations of GHG emissions: • Climate Policy Relevant Sectors: energy technology profile disclosed by CPRS-Granular • Renewable energy capacity (utility, source: BNEF and proprietary database of company reported data) • Green CAPEX (utility, source: BNEF and Refinitiv) • Algorithm to perform the climate-aware portfolio rebalancing shifting weights from bonds that are more exposed to transition risk to bonds less exposed to • Fig. 5 shows the consistency of the enhanced measure of greenness: the higher GHG emissions or ESG risk, the lower the greenness. • Rebalacing with enhanced greeness allows for portfolio decarbonization and reduction of ESG risk profile Fig. 5: Consistency of the enhanced measure of greenness, showing expected (negative) correlations with variables such as scope 1, 2, 3 emissions and ESG risk. Monasterolo_OECD_climate_transition_2022 9
  10. 10. Portfolio and market impact • We show that the ECB can reduce climate transition risk in its portfolio under weaker market neutrality defined as investing proportionally to the amount outstanding in eligible bonds by sector (CPRS 1, Figure 6) Fig. 6: Changes in portfolio weights within fossil and transportation sectors as a consequence of the rebalance. Fig. 7 : Market impact of the rebalance (0.01=100bp). Red: outliers. Grey box: boxplot of positive movements. Gold box: negative movements. Delta=1: move from Engie to Iberdrola • The market impact of the rebalancing on bonds held would be limited (average close to zero. Fig. 7) but can be larger for individual securities: • Delta: amount moved from more to less exposed bonds. Positive, net movement. Monasterolo_OECD_climate_transition_2022 10
  11. 11. Effective portfolio rebalancing requires economic policies • Market structure is still a constraint for portfolio rebalancing, also under weaker market neutrality, (Figure 5), see fossil and blue bars by country (nothing greener than OMV to buy in the same sector in AT) • Thus, greening monetary policy alone would not suffice. Economic policy are needed for structural change in the economy and market Figure 8: Exposure of the ECB portfolio by country of domicile and CPRS Main, after reclassification. Monasterolo_OECD_climate_transition_2022 11
  12. 12. Take away messages • Quantifying carbon stranded assets and their materiiality for finance is crucial to inform decision making (investors, financial supervisors, etc). European financial supervisors moved fast to meet the new challenge • However, being aware of the methodological challenges, and addressing them, is fundamental to avoid the underestimation of risks and opportunties in the transition • 2022, EDHEC-Risk and Climate Impact Institute (ERCII): research on finance impact on climate mitigation and adaptation. 12 Monasterolo_OECD_climate_transition_2022
  13. 13. References Battiston S., Mandel A, Monasterolo I., Schuetze F. & G. Visentin (2017). A Climate stress-test of the EU financial system. Nature Climate Change, 7, 283–288. Battiston, S., Monasterolo, I., van Ruijven, B., Krey, V. (2022). Mapping economic activities into climate scenarios and transition risk classes: the NACE-CPRS-IAM classification Technical report to the NGFS 2022 scenario report. Bressan, G., Monasterolo, I, Battiston, S. (2022). Sustainable investing and climate transition risk: a portfolio rebalancing approach. Journal of Portfolio Management, Special issue “Novel Risks”, forth. (previous version available at SSRN: abstract=3770192) CERES (2020): Financing a net-zero economy: measuring and addressing climate risks for banks. Report available at: https://bit.ly/3B850Jp Monasterolo_OECD_climate_transition_2022 13

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