Agefi Luxembourg - décembre 2024

Décembre 2024 13 AGEFI Luxembourg Economie / Banques C limate riskhas swiftlymoved to the forefront of strategic dis- cussionswithin the financial sector, transforming froma niche concern into a central pillar of riskmanagement. The growing interplay of Environmental, So- cial, andGovernance (ESG) considerations—particularly the environmental (E)—is driving regulatory change, investor scrutiny, and operational chal- lenges for financial insti- tutions. Given thepotential impact of cli- mate risks, the companies are ex- pected to integrate it into the risk framework and assess the potential financial ef- fectonthebusiness.Inthiscontext,climateriskmod- elling has emerged as a vital instrument, offering institutions a way to anticipate and manage risks linkedtoclimatechange.Thisarticleexploresthecore concepts,practicalsteps,andregulatoryimplications of climate risk modelling, with insights tailored to banks, insurers, and asset managers navigating this evolving landscape. Climate riskmodelling: What it is andwhy itmatters Theglobal financial sector is increasingly taskedwith understanding and addressing climate risks. These risks fall into two interrelated categories: - Physical risks reflect the direct impacts of climate change,suchasextremeweatherevents,risingsealev- els,andprolongeddroughts.Theseeventscandevas- tateinfrastructure,disruptsupplychains,andweaken economicstability.Forinstance,floodsinkeyagricul- tural regions may lead to defaults on farm-related loans, undermining credit quality; - Transition risks arise fromthe economic and regu- latory shifts required to transition to a low-carbon economy. New regulations, like carbon taxes or stricter emission standards, can devalue high-emis- sion assets, creating ripple effects in portfolios and markets. For example, banks heavily exposed to coal miningprojectsmayfacedecliningloanperformance due topolicy-driven closures. Whiledistinct,theserisksoftenconverge,demanding a nuanced understanding of their systemic and lo- calised effects. The drivers of climate riskmodelling The urgent focus on climate risk modelling stems from several factors. We see the most important among thembeing regulatory and compliance push, investors’ expectations, and long-termstrategic plan- ning. Global and regional regulatory bodies are in- creasinglyprescriptiveabouttheneedforclimaterisk integration. In Europe, the Capital Requirements Regulation(CRR) and CapitalRequirementsDirec- tive (CRD) mandate that banks include climate sce- narios in stress testing and incorporate climate-adjustedcapitaladequacymeasures.Insurers face similar scrutiny under EIOPA’s Own Risk and Solvency Assessment (ORSA) framework , which callsformulti-horizonriskassessmentsreflectingboth physical and transition risks.Meanwhile, the Corpo- rate SustainabilityReportingDirective (CSRD) en- forces transparency in how institutionsmeasure and discloseclimateimpacts,complementedbytheEuro- pean SustainabilityReporting Standards (ESRS). Investors are increasingly aligning their expectations with sustainability benchmarks, such as GreenAsset Ratios(GAR)anddecarbonisationgoals.Thistrendis driving institutions toquantify their climate risks rig- orously,ensuringalignmentwithbothregulatoryde- mands and market pressures. Beyond compliance, climate risk modelling provides a competitive edge. Institutions that effectively incorporate climate re- silience into their operations can identifynewoppor- tunities, such as financing renewable energy or climate-resilientinfrastructure,whilemitigatinglong- termfinancial vulnerabilities. The framework for climate riskmodelling Modellingclimateriskrequiresastructuredapproach that integrates robust methodologies with practical applications. The cornerstone of effective climate risk modelling lies in climate scenario analysis. This in- volves simulating financial outcomes under various climate pathways, ranging from optimistic (limiting warming to 1.5°C) to pessimistic (business-as-usual emissions leading to >3°C warming). Physical risks are modelled using tools like catastrophe models, which estimate damages based on the intensity and likelihoodofextremeweatherevents.Transitionrisks are assessed by examining regulatory changes,carbonpricing,andshiftsinmar- ketdemandforhigh-emissionindustries. Majority of experts agree on the follow- ingimportantstepstoconductthequan- titative climate risk assessment. 1. Set objectives : Institutions must de- finecleargoals,whetherit’stoenhance resilience, comply with regulations, preparingstresstestsoralignwithsus- tainability strategies; 2. Data collection and scenario analysis : Reliable climate and financial data underpin all modelling efforts. This in- cludes emissions data, geo- graphic exposure, sector- specific vulnerabilities and selection of relevant climate scenarios and tools. Many players of the financial mar- ket seeing the process of set- ting up the tailored climate scenarios as one of the biggest challenges. 3. Integration into financial models : Incorporate cli- matevariablesintocredit,market,andoperationalrisk models.Forexample,adjustingProbabilityofDefault (PD) calculations to account for carbon pricing im- pacts onborrowers’ cashflows. 4. Validation and review : Continually refine as- sumptions and update models to reflect evolving data and insights. Sector-specific applications: - Banks: Banks are leveraging climate-adjusted credit scoring to account for borrower vulnerability to climate shocks. For example, drought impacts on agricultural loans or the increased riskof default for industries heavily reliant on fossil fuels are inte- grated into their credit assessment models. Addi- tionally, banks are conducting scenario analyses to evaluate the resilience of their portfolios under var- ious climate pathways. Stress testing, mandated by regulations suchas theCRR, includesmodelling the financial impacts of regulatory shifts like carbon pricingor abrupt policy changes that coulddevalue high-emission assets; - Insurance companies : For insurers, climate risk modellinggoes beyondnatural catastrophe (NatCat) modellingtoincludedetailedscenarioanalysesforthe ORSA. Insurers use these analyses to evaluate the long-term viability of their business models under various climate scenarios. For example, they assess solvency implications under extremeweather events or transition risks from regulatory changes. Further- more,feasibilitystudiesfordevelopingnewinsurance products—such as parametric insurance for climate- sensitive regions or policies incentivising sustainable practices—are increasingly being informed by ad- vanced climate riskmodels; - Asset Managers: Asset managers apply portfolio- levelanalysestoevaluateexposuretohigh-carbonsec- tors. They also use climate risk models to identify strandedassetrisks,suchasinvestmentsincoaloroil- dependent industries that may lose value due to the energytransition.Additionally,scenarioanalyseshelp forecast long-term portfolio performance under different climate pathways. Tools like transition risk heatmaps or sectoral exposure dashboards enable assetmanagerstomakeinformeddecisionsondivest- ment strategies, green investment opportunities, and overall portfoliodecarbonisationplans. Integrating climate risks into broader frameworks Climate risk integration is not a siloed activity. It should permeate an institution’s overarching risk management and governance systems. The current guidelinesonhowtointegrateclimateriskintheover- allriskmanagementandassessmentprocessarevery muchalignedacrossthefinancialsector.Forexample, CRR requires banks to embed climate risks into their capital frameworks, ensuring adequate buffers against climate-related losses. This involves simulat- ing the financial impacts of climate shocks on credit risk metrics, such as Loss Given Default (LGD) and ExposureAt Default (EAD), and adjusting capital ra- tios accordingly. EIOPA emphasises a tailored ap- proach, urging insurers to adapt global scenarios to their specificportfolios andgeographic exposures for theORSAreporting. Insurersareexpectedtodocumenttheselectionofsce- narios comprehensively, providing transparency in how climate risks influence solvency. All the regula- tory bodies enforce the importance of the cross-func- tional governance framework where climate risk management should be overseen by dedicated com- mittees, ensuring alignment between sustainability, risk, and strategy teams.Advanced tools, such asAI- driven models and geospatial climate data, enable precise scenario analysis and real-timemonitoring. Conclusion As climate risks growmore acute, financial institu- tionsmustembracecomprehensivemodellingframe- works to anticipate, measure, and manage their exposures.Byembeddingclimateconsiderationsinto their strategies, institutions not only meet regulatory requirements but also position themselves as leaders in sustainable finance. The journey toward effective climate risk integration is complex but essential. Institutions that proactively adopt best practices in climate riskmodellingwill be better equipped to navigate uncertainties, seize new opportunities, and build long-term resilience in a rapidly changingworld. Alina VORONTSOVA Climate risk modelling driver Actuarial and risk modelling services Rym KACED Climate risk modelling associate Actuarial and risk modelling services PwC Luxembourg Climate risk modelling in the financial sector: Understanding, assessing, and integrating risks T he PwC Business Barome- ter experienced a drop of 5 points in November, rea- ching -9 by the end of the month. This decline is primarily attribu- ted to waning consumer confi- dence in Luxembourg and a persistent downturn in the construction sector. ConsumerconfidenceinLuxembourgfell by 5 points inNovember, with all indica- tor components showing unfavourable trends. The latest readings on consumer confidence coincide with warnings from the National Council of Public Finance (CNFP) that unemployment is set to rise in the coming years due to sluggish eco- nomic growth. The CNFP reported that employment growth is expected to slow sharply from an average of 3% over the pasttwodecadestojust0.9%in2024,with onlyamodestrecoveryprojectedthrough 2028. The unemployment rate is forecast to increase from an average of 5% over the past four years to 6% between 2024 and 2026, partly due to ongoing issues in the construction sector. According to the latest data from STA- TEC, while Luxembourg's GDP expan- ded by 0.2% in the third quarter of 2024 and1.2%onanannualbasis,theconstruc- tion sector's value added contracted by 0.2%quarterlyand5.4%comparedtoQ3- 2023. Despite the sector's crisis, housing pricesinLuxembourghavestartedtorise again,asaresultoftheinterestratecutsof thelastmonths.Housingpricesincreased by1%inthesecondquarter,withtheprice of apartments under construction going up by 9%, while prices of existing homes continued to fall by 0.8%. To sustain the positive momentum, the government has decided to extend tax benefits for housing until July 2025. This extension mainly concerns the "Bëllegen Act" tax credit for first-time buyers of owner-occupied flats and purchases of yet-to-be-built rental flats (VEFA). The prime minister emphasized that this will be the last extensionof these benefits. In the Euro Area, the economy fell back into contraction territory inNovember as business activity levels decreased at the fastest pace since January, amid a rene- wed decline in services output. Weak demand conditions persisted, with new private sector orders shrinking for the sixth consecutive month and at the shar- pest pace of the year. The economic contraction is occurring in a climate of high political uncertainty, highlighted by the collapse of the French government after Prime Minister Michel Barnier was ousted in a no-confidence vote on December 4th. This is the first instance of a French government collapsing in this way inover sixdecades. Thepolitical tur- moil inFrance adds to the uncertainpoli- tical landscape in Germany and a strug- glingEuropean automotive sector. In the wake of the tumult that impacted Volkswagen inNovember, Stellantis, one of the largest automakers in Europe and globally, is also encountering significant challenges.Thecompany’sCEOresigned in the firstweekofDecember amiddecli- ning profits and slumping sales in its key NorthAmerican region. Despite the tur- moil, companies in the Euro Area have registered positive expectations for the next12months,accordingtoS&PGlobal. However, the degree of optimism has waned to its lowest inayear and remains muchweaker than its long-termaverage. On a global scale, attention is focused on theMiddleEast,particularlySyria,where opposition forces took Damascus on December 8th, ending theAssad family’s 53-year reign in a surprise offensive that reached the capital in just 12 days. The stunning collapse of the cruel regime has been celebrated as a significant success in the country, but the future of the country and the region is now veiled in uncer- tainty as it remains unclearwhat the new government in Syriawill look like.While Syria was celebrating overthrowing its longtime dictator, Israel initiated a new groundincursionandawaveofairstrikes against320strategictargetsinthecountry, which drew international condemnation andconcern.Meanwhileatemporarycea- sefirewasreachedintheIsrael-Hezbollah conflict on November 27th, mandating a 60-day halt to hostilities. This initial attempt at peace appears fragile, Israeli airstrikes have continued against HezbollahpositionsinsouthernLebanon since the agreement. The monthly PwC barometer, in collaboration with AGEFILuxembourg, isaneconomicconfidence indi- cator that is intended to be a simple and pragmatic tool aimed at capturing the economic atmosphere of the Grand Duchy each month. The indicator is based on a number of sentiment indices published monthly by Eurostat and Sentix, which are based on surveys (businesses, consumers or investors/ analysts). The indicators used are: consumer confidence (EA for euroareaandLUXforLuxembourg),industrialconfi- dence(EAandLUX),constructionconfidence(EAand LUX),financialconfidence(EA),retailconfidence(EA), services confidence (EA) and the Sentix Index (EA). The evolution of the barometer over the past four years is displayed on the graph below. PwCMarketResearchCentre, IHSMarkit,Sentix,STATEC The monthly PwC Barometer