Integrating Climate Risks into Credit Risk Assessment: Current Methodologies and the Case of Central Banks Corporate Bond Purchases

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Climate change and the transition to a low-carbon economy to mitigate it engender significant economic costs. These costs are ultimately borne by households and firms, affecting their cash flows and wealth, which are key determinants of their credit worthiness. Climate-related costs are thus a source of credit risk.

An accurate assessment of all credit risks, including climate credit risk, is central for creditors including central banks. If they underestimate it, they are exposed to financial losses and to the risk of holding assets of inadequate credit quality.

Assessing climate risks requires methodologies based on forward-looking scenarios, on complex cause-and-effect linkages and on data that has not been observed in the past. Such models are at their infancy, but already offer meaningful insights. This note provides an overview of key components that such models are built on and illustrates them with examples of the analytics that are already available. It also applies one of the available methodologies to assess transition risk to the corporate bond holdings of the European Central Bank.