Projects: CFR2-TS

Estimating the impact of physical climate risks on the probability of default (PD) of mortgage loans in the coastal cities of China

Climate-related physical risks, such as typhoons, floods, and heat waves, will result in considerable damages and losses to the real economy and to the financial sector that provides financing for economic activities. Against this backdrop, the international financial community has been calling for attention and actions to integrate climate-related physical risks into financial decision-making by financial institutions. To manage environmental and climate risks, the primary step is to quantify these risks. However, literature that quantifies the implication of climate-related physical risks for the financial sector is very limited.

We present an analytical framework for measuring the impact of climate-related physical risks on the default risk of bank loans. We applied this method to quantify the increase in the probability of default of mortgage loans for properties in China’s coastal cities, caused by the increased intensity and frequency of typhoons under four commonly used climate scenario defined by the Intergovernmental Panel on Climate Change.

The preliminary findings of this INSPIRE study show that future typhoon events exacerbated by climate change along the coast of China could potentially lead to a considerable increase in the probability of default for mortgage loans, with a possible accumulation of incremental probability of default of more than 5%. This analytical framework can also be applied to many other scenarios of environmental and climate risk analysis for banks if the data required are available, such as impacts of floods and water shortages on credit risk of loans to sectors that are sensitive to such risks.

Assessing the Impact of Climate-Related Transition on Default Probabilities of Thermal Power Companies.

In this chapter, we present an analytical framework and the methodologies for measuring the impact of climate-related physical risks on the default risks of bank loans. The framework consists of the setting of climate scenarios and a suite of catastrophe models and financial models. For the case study, we analyzed the impacts of climate change on typhoons’ intensity and frequency and on credit risk metrics (e.g. PD and LGD) of mortgage loans in China’s coastal cities. The model shows that, under an extreme scenario (RCP8.5 with extreme exacerbation effect on typhoons), the expected annual credit loss of mortgage loans could rise nearly three fold in 2050 compared with the baseline scenario which assumes no change in typhoons’ occurrence pattern. This framework can also be applied to estimate potential climate exacerbated impacts of other natural disasters including floods, heatwaves, drought and wildfires on financial risk metrics such as default probability and valuation of assets.