The impact of climate change on investment risk and credit risk
Date
2023
Authors
Journal Title
Journal ISSN
Volume Title
Publisher
University of the Witwatersrand, Johannesburg
Abstract
ESG (Environmental, Social, and Governance) factors have evolved from being a minor consid- eration in the 2000s to a major factor for many companies in 2023. Many companies are now assigned ESG grades, which are closely examined by investors. While it would be ideal for re- sponsible firms to be rewarded and culprits to be penalised, this is not always the case in a profit- driven world. Investors are likely to always prioritise profitability, so some compromise is neces- sary. Recent efforts to balance corporate responsibility with portfolio performance are promising. Using Lagrangian calculus, portfolio optimisation techniques have been developed that show re- turns and risk profiles comparable to those of unconstrained portfolios (i.e., ones which did not consider ESG scores). As expected, low ESG scores influence portfolio performance negatively (as measured by the Sharpe ratio), but very high ESG scores have the same effect. Optimal ESG scores are those which represent the turning points of these relationships, i.e., those ESG scores which result in maximal Sharpe ratios. These optimisation techniques are applied to emerging market corporates for the first time. Over time, ESG scores have improved globally, at varying rates, and have resulted in a statistically significant decrease in risk and increase in returns. As volatility increases, optimal ESG grades rise slowly, and associated Sharpe ratios decrease, and it is postulated that this could be due to the option-like relationship between underlying volatility and inherent value. With a better understanding of trends, asset managers who consider ESG met-rics can confidently assert that ESG compliant portfolios do generate healthy risk-adjusted returns (Sharpe ratios) and that these values are improving over time. ESG compliant portfolios are now viable investments that align with responsible investment principles. Firms must estimate expected credit losses (EL) to comply with accounting standards and unex-pected credit losses (UL) to determine regulatory credit risk capital. Both rely on estimates of obligor probabilities of default (PD). Changes in climate, however gradual, increase firm default rates and climate shocks such as floods or droughts exacerbate these impacts. Investors pay close attention to credit ratings which are derived from inter alia default rates, but studies investigating the impact of climate change on PDs are currently limited and data are still relatively scarce. Africa will be most severely impacted by climate change: default rates will deteriorate leading to in- creased PDs, losses given default (LGDs), provision requirements (through increased ELs) and vi regulatory credit risk capital (through increased ULs). To investigate these effects theoretically, corporate equity prices are simulated using Geometric Brownian Motion (GBM) and shocks brought about by climate events of differing frequency and severity are applied to these simulated prices. Post shock prices and return volatilities are differentially affected depending on the nature of the applied shock. These are used as inputs into a well-known Merton (1974) model of corporate default from which market-implied PDs may be extracted. A possible calibration approach is developed for climate event-based impacts on corporate default rates. A scaling factor matrix (an amount by which the unaffected default rate increases after a specified climate event type occurs) can help market participants forecast default rate changes. Climate related impacts have been quan- tified, calibrated, and used to assess credit quality degradat
Description
A research report submitted in partial fulfillment of the requirements for the degree of Master of Commerce to the Faculty of Commerce, Law and Management,School of Economics and Finance University of the Witwatersrand Johannesburg, South Africa, 2023
Keywords
ESG (Environmental, Social, and Governance), Climate change, Investment risk, Credit risk, Climate change impact, UCTD
Citation
Bell, Francesca. (2024). The impact of climate change on investment risk and credit risk [Master’s dissertation, University of the Witwatersrand, Johannesburg]. WifreDSpace. https://hdl.handle.net/10539/38745