medium · FRM Part 2 Current Issues

Which statement BEST captures the deepest methodological obstacle climate risk poses to standard VaR/capital modeling?

1. Climate outcomes are deeply uncertain and path-dependent on policy and technology with non-stationary, non-linear, potentially irreversible tipping dynamics, so historical data cannot calibrate the loss distribution and the risk resists the stationary-distribution assumptions underlying VaR-style capital.
2. Climate risk is treated here as purely idiosyncratic to each individual obligor rather than systematic across sectors, so it diversifies away almost completely at the portfolio level, and the only modeling challenge left is collecting sufficient emissions data to estimate the residual.
3. The obstacle, on this view, is that climate losses are always extreme tail events carrying essentially zero probability mass in the body of the loss distribution, so they can simply be excluded from VaR entirely and handled instead through a fixed regulatory capital add-on buffer sized once and left unchanged thereafter.
4. Climate risk is fully captured, on this reasoning, by simply extending the VaR horizon out to roughly thirty years and applying a materially higher confidence level, after which the standard parametric framework applies without further modification.

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