The impact of climate change - a seemingly distant crisis, is being felt more than ever across regions and economic sectors. The financial implications of it, for one, have been dire. In a groundbreaking report, the Carbon Disclosure Project stated that unless preemptive measures are taken, 215 out of the 500 largest companies in the world could lose about one trillion dollars due to climate change. More than half of these risks were reported to most likely materialise in the coming five years, if not sooner. Further, physical and transition risks linked to stranded assets were assessed to potentially cause US$250 billion in losses.
The increasing recognition of these vulnerabilities has shifted the focus to climate-related risks, managing which is crucial to protect financial portfolios and bank exposures. In this regard, many tools and approaches have been developed over the years to measure financial risks. Read more about climate risks and the tools to manage them in our blog here. One of the most popular and established measures of risk in financial firms that is accepted across regulations is Value at Risk (VaR).
Value at Risk (VaR)
A measure of loss for investments, the VaR model analyses the volatility of a portfolio. It estimates how much the value of a portfolio could decline given a specific period of time at a given confidence level. This can help investors and managers make more informed decisions about allocating their assets and managing risks.
For example, if the 95% one-month VaR is $1 million, there is 95% confidence that over the next month the portfolio will not lose more than $1 million.
VaR estimates are useful for portfolio managers and investors to gauge the potential impact of market movements on their holdings.
VaR has emerged as one of the most popular risk assessment approaches in the financial sector due to its many use cases. These include:
VaR provides a consistent and objective way to measure and compare the potential losses on different investments, which facilitates efficient capital allocation.
It can be used to set risk limits and develop risk management strategies, such as buying insurance or diversifying the portfolio, to reduce the potential losses on an investment.
VaR is used to evaluate the performance of a portfolio over time by comparing the realised losses with the VaR estimates. This can provide valuable information for adjusting the portfolio and improving risk management.
It is also used as a basis for regulatory capital requirements by setting minimum capital levels that are needed to support the potential losses on an investment.
Through VaR modelling, risk managers can undertake risk analysis for both specific positions as well as for the entire firm. These insights allow an entity to assess if they have sufficient capital reserves to make up for the losses or if they need to take additional measures to deal with the potential crisis effectively. This further helps companies understand how the climate change crisis could impact their valuations.
Methods to Calculate VaR
There are several different methods that can be used to calculate VaR depending on the specific investment being evaluated and the goals of the analysis. The most popular methods include:
Historical VaR: This is based on the historical performance of an investment and uses past data to estimate the potential loss on an investment over a given time period.
Parametric VaR: This type of VaR uses statistical models to estimate the potential loss on investment based on assumptions about the distribution of returns.
Monte Carlo simulations: Here, simulations are used to estimate the potential loss on an investment by generating a large number of possible future scenarios and calculating the potential loss for each scenario.
Variance-covariance VaR: This is a simplified method of calculating VaR that assumes that the returns on an investment are normally distributed. It is often used for portfolio risk management.
Overall, the choice of which type of VaR to use depends on the specific investment being evaluated, the goals of the analysis, and the availability of data and other resources.
VaR modelling has emerged as a popular choice having acceptability across most regulatory authorities, owing to its several advantageous characteristics. This includes comparability, as it can be used to assess the market risk of asset classes with different risk characteristics. In addition, it is easy to interpret since VaR is measured in currency or percentage format, making it convenient for analysts.
However, despite its many benefits, VaR is not a perfect measure of risk. For instance, VaR does not articulate the expected losses if it moves beyond the minimum threshold and is difficult to calculate for more extensive portfolios. Further, it only provides an estimate of potential loss and is based on assumptions about the future behaviour of financial markets. While it is not a guarantee of future performance, it is, however, an important tool in a broader risk management strategy.
While VaR has been typically used to measure traditional financial risks such as market, credit and operational risks, the worsening financial impact of climate change has led to the incorporation of climate risks as well. In this regard, Climate Value at Risk (Climate VaR) has emerged as a new measure to estimate the potential financial losses that a company or portfolio of assets could incur as a result of climate change. It is similar to VaR, but focuses specifically on the risks and opportunities associated with climate change.
Climate VaR is typically calculated using a combination of historical data, modelling techniques, and scenario analysis. The resulting estimate provides a range of potential financial losses that a company or portfolio could face as a result of climate-related events, such as extreme weather, sea level rise, or changes in temperature. This information can be useful for investors and companies to evaluate the potential impact of climate change on their financial performance and to identify opportunities for mitigating or adapting to these risks. For example, a company with a high Climate VaR may decide to invest in renewable energy sources or climate-resilient infrastructure to reduce its exposure to climate-related risks.
Role of Data
While Climate Value at Risk is a useful tool for measuring the impact of climate change on investments or credit exposures, the accuracy and credibility of this approach is driven by the quality of data, as these tools are only as good as their inputs. High frequency, climate data from observations for a range of physical risks are critically important in calculating Climate VaR as it is necessary to have long range historical climate data related to the assets and collaterals in an investment or credit portfolio.
In addition, data with high granularity is also important. This includes geolocation data to assess physical risks and data on climate risk drivers. Likewise, high-frequency data is important to find a correlation, which is essential to arrive at an accurate Climate VaR. This helps in identifying risks and accordingly take the appropriate course of action.
Climate VaR is a valuable tool for assessing and managing the financial risks associated with climate change. It can help companies and investors better understand the potential impact of climate-related events on their financial performance and make more informed decisions about managing these risks. The role of high-resolution, high-frequency and granular data cannot be understated as it helps in measuring physical and transition risks associated with climate change. This further helps the model to accurately reflect a portfolio's risks and potential losses. Credible data, thus, is the foundation upon which Climate VaR is built.