Worldwide energy price shocks, crop and water shortages, migration from low-lying areas, and increasing trade tensions. These are just some of the climate-related challenges societies will confront in coming years. Financial actors are increasingly looking to understand the unique risks and opportunities presented by climate change. Financial regulators have also taken notice. As Federal Reserve (Fed) Governor Lael Brainard stated, “climate change and the transition to a sustainable economy also pose risks to the stability of the broader financial system.”
Stress Testing: A Regulatory Tool
In the aftermath of the Global Financial Crisis, many financial supervisors recognized that systemic financial risks had been overlooked, and these risked had wreaked havoc on the world economy. Determined to mitigate future financial crises, supervisors sought to ensure the resiliency of the financial system and individual institutions to financial risks. Stress testing has been a central tool in these risk and resiliency assessments. These exams evaluate firms under a variety of economic scenarios and consider their performance and capitalization.
As climate has become a widely acknowledged financial risk, supervisors are creating climate stress tests to better understand the magnitude and nature of climate risk. The Netherlands’ Central Bank (DNB) was among the first central banks to develop a climate stress test. The Bank of England (BOE) and the European Central Bank (ECB) have now designed mandatory exams to evaluate both short-term and long-term climate risks. The U.S. Fed recently published a paper on climate stress metrics, and a number of other global regulators have announced plans for stress tests in 2022.
Four Considerations for Executing Climate Stress Tests
While these tests differ in certain ways: specific scenarios used, granularity of analysis required, and types of risks considered, they share some common features. Most tests attempt to explore climate risks both qualitatively and quantitatively. The quantitative element typically involves assessing losses overall and across different portfolios under different scenarios. It can also involve specific counterparty-level analysis to probe the climate risks of major clients. The qualitative element focuses on management actions taken to reduce climate risk and capitalize on new opportunities over the course of the scenario. This narrative may discuss climate governance, client engagement strategies, and the firm’s decarbonization targets.
Developing a complete picture of a firm’s climate risks requires strong organizational coordination. Financial institutions are currently mobilizing resources to meet the demands of climate stress testing. Those demands involve leveraging existing risk infrastructure and developing new, climate-specific capabilities. In preparing for climate stress testing, firms should consider team structures, data, models, and outputs.
Conducting a climate stress test is a major undertaking for a financial institution. While the Risk department typically leads the exam’s execution, other teams across the firm are vital to its successful execution. Colleagues in business line functions should provide insights about clients and evaluate the potential business implications of the various scenarios. Economics teams should assess the scenario variables and make assumptions to adapt them to the institution’s circumstances. Senior management must be accountable for the results of the exam and for promoting strong climate risk governance. Overall, the firm should invest in enhancing climate knowledge throughout and work to integrate climate risk considerations into new and existing processes.
The right data
Even with well-defined roles and responsibilities, successful execution demands good data. The data required for climate stress testing fits into two categories: traditional financial data and climate data. Traditional financial data is already needed to conduct current stress tests and evaluate portfolio and client risks. Climate data is typically less well-integrated into institutional processes. Some climate-related data will come directly from scenarios and offer high-level detail on physical risks and transition pathways. However, for physical risks, firms will need to work closely with clients and data providers to granularly assess the diverse physical hazards confronting specific assets over different timeframes. For transition risks, firms must be able to measure client emissions and evaluate client transition plans.
A central part of climate stress testing, and other forms of climate scenario analysis, involves converting climate-related factors into financial impacts. Whether for physical risks or transition risks, this exercise entails identifying climate-related risk drivers, integrating them into financial risk models, and generating losses and other outputs. Existing stress testing models can be a useful starting point to consider the relationship between financial risks and losses. However, firms often must develop or deploy specific climate risk models to take in climate stress testing scenarios and produce portfolio losses. Depending on the nature of the test, a wide range of models may be applied, from risk rating scorecards for individual counterparties to econometric regressions for portfolio-level default rates.
Interpreting the results
Climate stress testing involves aggregating model results to generate a perspective on a firm’s overall climate risk. As such, exam outputs include both the quantitative assessments on climate losses and the firm’s qualitative strategic plan to manage its climate risks. While these outputs aim to meet regulatory requirements, they also have other important applications. Stress testing outputs can be used to enhance risk management practices and inform the setting of firm-level risk appetite. Results can also be used to develop new business strategies to capitalize on climate opportunities. Outputs can also improve client engagement and underwriting processes to better address climate risks.
Global financial regulators have made clear their plans to expand the use of climate stress tests. New tests may feature additional scenarios and risk types and may carry capital or compliance implications for inadequately prepared firms. New tests mean rising expectations for financial institutions. However, firms will also gain insights into their climate exposures and be better prepared to thrive in a changing world. The United Nations Environment Programme’s Finance Initiative (UNEP FI) has developed a comprehensive guide to help institutions understand the nature of climate stress testing and prepare to effectively execute a stress test. That resource can be found here.