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Nicole Seaman

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Learning objectives: Discuss the history of climate change-related risks for the financial sector including the Paris Agreement (2015) and distinguish the significance of Article 2.1 c as it pertains to the financial system. Distinguish the causes of potential mispricing of climate change risk and the impact of relevant history and data, non-normal probability distributions, kurtoses, skew, “black swan” events, and risk materialization time horizons on pricing as compared to traditional investment risk analysis. Discuss recent reporting and disclosure requirements under Article 173 of the French Energy Transition Act and the impact of The European Commission Sustainable Finance Action Plan on the allocation of capital towards sustainable investments and inclusion of climate and environmental factors in financial institutions’ risk management policies.

(Source: Hugues Chenet, “Climate Change and Financial Risk,” Social Science Research Network, June 25, 2019.)

20.6.1. In the recent history of climate change, which of the following (in Hugues Chenet's words) constitutes "the basic framework on which all financial institutions, private and public, work"?

a. The socially responsible investment (SRI) framework
b. The Paris Agreement, which set explicit long-term temperature targets
c. The Kyoto Protocol which triggered the dramatic rise and success of carbon markets
d. The Green Credit Guidelines along with the standards (aka, specifications) defined by the World Bank's first green bond

20.6.2. According to Hugues Chenet, there are at least five reasons why climate-related risks are not captured (and therefore mis-priced or not priced) by the usual risk management frameworks. The following are these reasons:

I. Unprecedented phenomena: no historical nor statistical data are available to feed the usual risk analyses that are often based on ergodic models​
II. Radical uncertainty: climate-related risks are not computable Knightian risks but rather unmeasurable, unquantifiable, and characterized instead by qualitative possibility​
III. Non-normal probability distributions: climate-related risks are fitted poorly by the normal distribution, as they exhibit significant kurtoses and skews​
IV. Bounded rationality: balances sheets are bounded by liability constraints and it is rational for firms to allocate assets according to their balance sheet boundaries​
V. Discrepancy in time horizons: undoubtedly the most fundamental, the most significant impacts happen in decades, which a longer time horizon than is typical for finance​

Each of the reasons above is correctly defined, at least according to the reading's author, EXCEPT which is incorrectly defined above?

a. Unprecedented phenomena
b. Radical uncertainty
c. Bounded rationality
d. Discrepancy

20.6.3. According to Hugues Chenet (in his paper, Climate change and financial risk), financial risks related to climate change were largely marginalized until recently. However, recently the financial risks associated climate risk have experienced a "booming phase" and the topic is now mainstream. About this important trend, according to Chenet, each of the following statements is true EXCEPT which is false?

a. The primary approach to (i.e., tool for) climate risk assessment is scenario analysis
b. Climate-related risks split into two broad categories: physical risks and transition risks
c. The chief strength of the Task Force on Climate-related Financial Disclosures (TCFD) is that it is a mandatory framework with precise technical requirements
d. The most effective regulatory initiative toward a prudential framework was the action plan deployed by the High-Level Expert Group on Sustainable Finance (HLEG) and adopted by the European Commission (EC)

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Nicole Seaman

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Hi May I ask how can I view the answers to the above questions? Thanks.
Hello @mliang92

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