Climate change valuation adjustment: introducing a climate change scenario extrapolation to long dated CDS curve

The global climate crisis has triggered the financial sphere to address the way in which it conducts business. Climate risk consideration is currently growing in the banking industry but should also be considered by banks in the Credit Valuation Adjustment (CVA) when pricing derivatives.  

The credit risk for long dated derivatives (beyond 10 years), reflected in Credit Value Adjustment, requires CDS curves that are only traded up to 10 years. Banks must resort to extrapolating these curves based on their own assumption (occasionally corroborated with auction trades or broker quotes). As climate change impacts long predated credit risk, a CDS curve extrapolation factoring climate change can be considered for counterparties most likely to be impacted.

The methodology introduced in the article to derive the climate change impact on CVA, namely Climate Change Valuation Adjustment (CCVA), is inspired by the article of Kenyon and Berrahoui, 2021. The following offers a second methodology based on an alternative extrapolation of the CDS curve derived from the adjustment of IFRS9 credit risk models to include transition risk scenarios.

The objective is to link the long-term credit risk impacted by a behavioural change in the market in response to the implementation of various policies aiming to transition towards a carbon-neutral economy. Transition risk refers to financial losses that a corporate may incur, directly or indirectly, because of the process of a lower carbon transition and a more environmentally sustainable economy. The potential impact of this transition risk on the CVA for the banking industry is highlighted in this article mainly focusing on European Corporates. As transition risk does not affect Financials and Industrials in the same way and intensity, the following sectors have been selected to represent the latter: Automobiles, Oil companies and Insurance & reinsurance companies.

Learn more about how to account for the climate change impact in the attachment below.