In analysing the impact of climate related shocks, a short-term, instead of long-term approach should be taken, and focus should be put on the effects on market risk, not the macroeconomic hit, writes ISDA CEO Scott O’Malia in a commentary. A report by his organisation attempts to guide financial institutions in their climate scenario analysis.

In a survey conducted last year, the International Swaps and Derivatives Association (ISDA) found that climate scenario analysis is now a priority in many banks. Yet, the lack of standardised methodology and reliable data make it a challenge. Working with Deloitte and more than 30 banks, ISDA has attempted to create what it describes as a “blueprint” for climate risk management titled A Conceptual Framework for Climate Scenario Analysis in the Trading Book.

Short and sweet

The framework states that “there is now growing recognition that climate related financial risks could also materialise within much shorter time frames and through a variety of different transmission channels”, which is why it is designed for scenarios with short-term horizons running days, weeks, or months instead of years or decades. In addition, Scott O’Malia points out that translating a macroeconomic shock into market risk parameters is especially important when it comes to climate analysis because there is less historical data in this space.

The framework is underpinned by five stages – objective, scenario development, data, shock generation, and impact assessment. Each stage comes with a set of key considerations that were suggested by an industry survey and insights from a working group, such as the establishment of a use case, and the adoption of a static balance sheet.

ISDA intends to pilot the framework in the second half of this year to “test its usefulness” and to “generate some estimates of potential climate risk impacts on a set of hypothetical portfolios”.