As climate-related events continue to occur with increasing frequency and severity, environmental risks need to be considered in the trading book given the value of financial instruments that may be affected by environmental factors.

As a result, potential financial risks arising from climate change remain a key area of focus, particularly for investors and regulators. As part of a May 2022 discussion paper, the European Banking Authority noted that environmental risks can materialize through market risk and the trading book via multiple channels. For instance, the transition to a low carbon economy can impact commodity markets (eg, fossil fuels), and physical risks emerging from climate change can cause market price fluctuations, such as more frequent and severe extreme weather events causing losses in equities due to the destruction of firms’ assets or capacity to produce.

Scenario analysis is a core tool to help inform strategy and business decision-making by assessing the scope and severity of these risks. However, much of the focus from regulators and banks has so far been on credit risk impacts in the banking book. How these risks affect the trading book has received less attention and research, and inclusion in regulatory exploratory exercises has been limited (eg, a carbon price shock in the European Central Bank’s (ECB) short-term disorderly transition risk scenario).

In the third quarter of 2022, ISDA and EY conducted a survey of ISDA members to provide a better understanding of the maturity of firms’ approaches to climate risk and scenario analysis in the trading book. The survey also sought to explore bank target states and the key challenges affecting their ability to achieve this. Click on the PDF below to read the full report.