Climate and environmental risk factors in the market risk field: An extended model

Abstract

The extension of the risk management models to the broad sustainability concept is an open issue in both the academic and financial communities. The current state of the art for the risk measurement models is not satisfactory. There are many weaknesses in the data feasibility and the debate about what the new models should measure is still open. We propose a model that aims to improve the existing market risk models by capturing the sustainability risk sources. The starting point is the incremental risk charge (IRC) model, namely a 1 year 99.9 percent value at risk that covers default and migration risk. We extend the traditional model by defining the environmental incremental risk charge (E-IRC), with two enhancements: 1) by some data analysis and statistical techniques we introduce some new environmental, social, and governance (ESG) risk factors to better explain the portfolio behavior; 2) we adjust the default probabilities provided by the rating agencies by combining the green premium (lower spread) observed in the markets with the available ESG score for each obligor. The new model was tested on a real portfolio by a Montecarlo engine. The model does not affect too much the existing IRC results, so allowing continuity in the reporting process. The main advantage of E-IRC is the availability of a more effective risk decomposition process, where the ESG contributions can be properly highlighted.