Climate risk in a loan book, from hazard to capital

01Four questions from hazard to capital

The lecture opens on three loans that today's probability of default ranks one way and a stress test ranks the other, answers four questions in four parts, and closes on a checkpoint of six questions with fresh numbers. The sheet holds the three loans, the coverage grid, the formulas, an exercise for pairs with its check values, and a glossary.

1. 01

   Climate risk in a loan book, from hazard to capital

   Which climate risks reach a bank's loans, how a hazard changes a borrower's probability of default and loss given default, how a bank measures the loss across scenarios, and what it does about the loss it measures.

   Puzzle: The coal power plant has the lowest probability of default of the three borrowers, 1.0 per cent, yet under the stress test its loan loses USD 11.25 m against the solar farm's 1.375 and the garment maker's 0.90.

   Slides PDF· Sheet PDF

02Three loans of USD 100 million

The three borrowers are stylised. Money is in millions of US dollars; earnings are a year's earnings before interest, taxes, depreciation and amortisation; emissions are a borrower's own, its Scope 1.

The stress test applies a carbon price of 100 US dollars of 2010 per tonne in 2030, the low end of the range the Network for Greening the Financial System gives for its Net Zero 2050 scenario, and a flood that removes 15 of the solar farm's earnings and a quarter of its collateral. The coal plant's earnings fall from 84 to minus 216, its probability of default rises from 1.0 to 25 per cent, and the capital the bank holds against the loan rises from USD 9.69 m to 25.89 m. The six lectures on the mathematics of green finance risk management derive the carbon price paths and the IRB capital formula that the lecture takes as given.

03Licence and files

The lecture is developed by the University of Twente and released under a Creative Commons Attribution 4.0 International licence (CC BY 4.0). It may be reused, adapted and redistributed, including commercially, with the attribution Climate risk in a loan book, from hazard to capital, University of Twente, GREEN FINANCE (Erasmus+ CBHE, Grant 101237817), CC BY 4.0. A question or a correction goes to Joerg Osterrieder, University of Twente, joerg.osterrieder@utwente.nl. The module's other teaching materials are on the Module 4 teaching page.