Estimating the impact of climate change on credit risk

With climate change, physical and transition climate risks are increasing and affecting the credit risk characteristics of individual obligors and portfolios of credit obligations, such as credit cards, mortgages and loans. To accommodate the effects of physical climate risks, we first estimate the frequency of extreme weather events for different US states by using state-specific meteorological data. Using these estimates, the probability of default is calculated for an obligor in a particular state. For a pair of obligors, a closed-form expression (up to a summation) is derived for the probability of default of two companies. A recent Bank of England conference addressed the importance of scenario analysis. This paper shows how to incorporate the effects of physical and transition risks using a multiperiod scenario analysis. This facilitates the estimation of different risk measures. Physical and transition risks can significantly increase the probability of default, value-at-risk and expected shortfall. The magnitude of these changes depends on the nature of the different risk parameters and the initial creditworthiness of a company.