The Next C of Credit
Hint: It’s “Climate”
Before coming to Jupiter Intelligence, I spent most of my career at a bank. One of my favorite former executives introduced me to the concept of the “Cs of Credit.” I have since found lists of many lengths referencing the Cs of credit in subsequent research. I quickly found articles claiming between three and eight “Cs of credit.” The quantity of Cs isn’t relevant, however. The critical point is none of these lists of Cs include the most important C — The C for Climate.
To start us off, let’s review the original five Cs (I learned it with five, so let’s start there):
- Capacity: The ability of a borrower to repay a given loan.
- Capital: The down payment. How much “skin in the game” does your borrower have?
- Collateral: A secondary source of repayment in the event a borrower defaults. Your home is the collateral for your mortgage, which is why the bank gets your home in foreclosure if you stop paying.
- Conditions: What is the present condition of the market? For a mortgage: are home prices increasing? For a small business loan: is your product going to sell? These are essential things to consider when approving a loan.
- Character: What are the characteristics of the borrower? This one is tricky because federal regulations restrict what a lender can consider, but some items are allowed. Considerations like educational background, personal credit history, and work experience can all be used to evaluate borrowers.
Climate is Changing the Credit Landscape, Too
These Cs all make great sense to a legacy (pre-climate change) credit landscape. They address a common existing risk related to consumer and business lending. But today’s loans are issued in a physical climate that is changing — and changing fast. For example, consider the size of damages to the mortgage market predicted by the recent ECB stress test recommendations (a whopping single year 45% loss), the 2018 UCS report, and the recent HKMA climate stress testing results. Or, consider the billions in damages created by the Texas power outages last winter. These are just studies I happen to have read recently. Finding additional examples of massively expensive weather-related disasters is easy.
NOAA recently put out this excellent graphic:
Created by the National Center for Environmental Information (NCEI) at NOAA, this image is a masterwork of an infographic. I hope Edward Tufte would approve; I certainly do. The above image is only a small part of a massive online repository of data from NOAA. This figure focuses on the location of the twenty $1B+ disasters in 2021. The full dataset provides information about the relevant metrics for the intensity and frequency of weather-related disasters since 1980. The online portal they have created is excellent: it summarizes and presents these data in a very user-friendly format. I highly suggest spending some time browsing the site. Spend any amount of time with these data, and one point is clear: the cost of weather and climate-related disasters is increasing significantly.
A deeper inspection of the NOAA data reveals that the total cost of disaster events in 2021 was $145 billion. The total cost for the last five years was $742.1 billion. This figure is over a third of all climate damages experienced since 1980. Climate change is here, and we are experiencing increasingly damaging disasters that often have roots connected to that change. Given that we are still far behind the emissions reductions needed to meet the Paris climate agreement’s 2-degree warming target, it is worth emphasizing (yet again) the clear and present nature of these risks.
Climate Risks: Clear, Present, and Increasing
The risks are not only clear and present but increasing. For example, consider another impactful graphic from NOAA that is often cited in media emphasizing climate-related risks:
This chart has been around for a while and it is regularly updated. An older version of this chart is one of the first things that encouraged me to switch my career from building real estate mortgage models to one focused entirely on climate issues. The relationship between time and disaster frequency in the chart is pretty flat over the first half of that chart. Then, after 2005, the trend increased dramatically. To paraphrase Dr. Katherine Hayhoe: we had weather disasters every three months in the ’80s and ’90s that cost us over a billion dollars; today, we have weather disasters on that scale every three weeks. Below is a figure I created containing a much-simplified version of the same data:
In this figure, I have included trendlines for two periods — the period before 2005 and the period after 2005. I pick 2005 here as it represents a nice visual break in the trends, and I dub the pre-2005 period “Baseline.” Before 2005, the trendline slopes slightly upward, but the slope is not statistically different from zero (i.e., we can’t claim with confidence this line isn’t flat). The line slopes dramatically upward in the second period and is highly significant. This simple figure isn’t a rigorous statistical analysis, but it is highly motivating.
Another critical thing to note is that this is not a chart showing the path of climate change. This chart is essentially about accounting. It’s dollars and cents. The word climate isn’t even on the chart. I want to be careful with this point, as attaching the blame for weather disasters to climate change is a whole branch of climate science, called Attribution Science, and I am making no serious attempt to join that field with this blog. Yet, the results certainly are motivating. There has been a clear regime shift in the scale of damage from the weather over the years. As the retired head of the National Weather Service, Louis Uccellini, recently pointed out:
“There’s still some debate about exactly how it’s related to climate change, but there’s some fundamental physics going on here, of a warmer atmosphere and warmer ocean providing more fuel for these hurricanes.”
That quotation is about hurricanes in particular but the logic applies to many types of weather events that can be related to climate change.
With that in mind, let’s consider another exciting chart. This figure displays the global mean surface temperature change according to historical observations and various climate change scenario projections. It is from the IPCC working group 1 report released last August. This report was specific to physical science and climate change. It is only the first of three reports to be released during this round of IPCC reporting, known as AR6 since it is the sixth round of reporting:
The scale of this chart may mask one significant fact. There is a large increase in the slope between the baseline period and the present. That may be hard to see as the increase continues colorfully and dramatically past the current year. But the increase between 2005 and 2020 is visible in the grey line. Hovering near 0.5 degrees C in the baseline period, it is well past one degree at this moment. Some back-of-the-envelope math shows us this is a 100% increase in this fundamental climate metric over that period. If the change in the slope of observed data in the above chart is not convincing enough, consider this zoomed-in view from another figure in the summary for policymakers of the same AR6 WG1 IPCC report:
In the second panel of the above figure, the dramatic increase in surface temperature changes before 2020 can easily be seen.
I am very aware that correlation is not causation, and one should be careful to note that society will adapt over time to some of these risks. Even so, it’s hard not to see a similarity between these two charts. They both show a trend in data that is increasing and increasing fast. Observe the jump between the value in 1995 and 2020 in both charts.
Notably, this is a realized actual change in outcomes in both charts, not a modeled climate projection. With the relatively small existing and recent jump in global temperature, we have seen billion-dollar disaster frequency increase by over 300 percent compared to the period around 1985–2005. Over the next 30 years, this temperature metric is likely to rise up to another 100% relative to today. Imagine the devastation if the current pace of billion-dollar disasters increases at this rate for 30 more years. Again, simple math shows us that, absent significant adaptation or mitigation, 60+ billion-dollar events may occur in the United States alone by 2050. It would be both morally and financially unsound not to be concerned about the financial system’s stability with such a large quantity of annual shocks potentially on their way. The climate services industry, and Jupiter, exist to provide insights on where those potential 60+ billion-dollar events are likely to happen.
Climate Metrics Exist Now to Inform Credit Evaluations
Luckily (as I have pointed out), it is not all bad news. Forward-thinking finance professionals can adapt, thrive and help mitigate the risks of climate change. We can do this today because (as I have also pointed out) it is possible to obtain incredibly precise and granular information about climate risks and use these to inform credit decisions. They just need the proper data to do the evaluations. And that data include one more C, that is the C for Climate. Jupiter exists to provide the best version of this climate risk data to the financial system.
With that, let us revisit the list of the Cs of Credit:
- Capacity: The ability of a borrower to repay a given loan.
- Capital: The down payment.
- Collateral: A secondary source of repayment in the event a borrower defaults.
- Conditions: What is the present state of the market?
- Character: What are the characteristics of the borrower?
- Climate: Given the best available data and the assumptions made by the lending institution about climate scenarios, what are the relevant climate metrics for this loan?
Conclusion
I’m making a simple point: Climate change is an emerging threat to financial stability. Plus, it is not necessary to rely on models of the future with all their uncertainties—the climate change signal is already in the observation records as defined in the figure above. Climate change results from corporate entities emitting carbon without cost and treating our oceans and sky like an open sewer. As it results from unpriced climate pollution, climate change is an economic problem. This blog describes why I strongly believe physical climate risk is also a financial problem.
Ryan Vaughn, PhD is a Technical Product Manager at Jupiter Intelligence. Learn more about Jupiter at jupiterintel.com.
References
NOAA National Centers for Environmental Information (NCEI). U.S. Billion-Dollar Weather and Climate Disasters (2022). https://www.ncdc.noaa.gov/billions/.
Smith, Adam B. (2020). U.S. Billion-dollar Weather and Climate Disasters, 1980 — present (NCEI Accession 0209268). NOAA National Centers for Environmental Information. Dataset. https://doi.org/10.25921/stkw-7w73.
IPCC Sixth Assessment Report, The Physical Science Basis: https://www.ipcc.ch/report/ar6/wg1/.
