Worldwide energy price shocks, crop and water shortages, low-lying migration and rising trade tensions. These are some of the climate-related challenges that society will face in the years to come. Financial actors are increasingly trying to understand the unique risks and opportunities presented by climate change. Financial regulators have also taken notice. as Governor of the Federal Reserve (Fed) Lyle Brainard Having said, “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
After the global financial crisis, many financial observers recognized that systemic financial risks were overlooked, and that these risks wreaked havoc on the world economy. Determined to mitigate future financial crises, observers sought to ensure the financial system and individual institutions’ resilience to financial risks. Stress testing has been a central tool in assessing these risks and resilience. These exams evaluate firms under various economic scenarios and consider their performance and capitalization.
As climate becomes a widely accepted financial risk, observers are creating climate stress tests to better understand the magnitude and nature of climate risk. Netherlands Central Bank (DNB) It was one of the first central banks to develop a climate stress test. Bank of England (BOE) And this European Central Bank (ECB) has now designed mandatory examinations to evaluate both short-term and long-term climate risks. US Fed recently published A paper on climate stress metrics, and several other global regulators have announced plans for stress testing in 2022.
Four ideas for executing a climate stress test
While these tests differ in certain ways: the specific scenario used, the granularity of the analysis required, and the type of risk considered, they share some common characteristics. Most tests attempt to detect climate risks, both qualitatively and quantitatively. The quantitative element generally involves estimating losses across different portfolios as a whole and under different scenarios. It may also include specific counterparty-level analysis to examine the climate risks of key customers. The qualitative element focuses on management actions taken to reduce climate risk and capitalize on new opportunities across the landscape. The narrative may discuss climate governance, customer engagement strategies and the firm’s decarbonization goals.
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 include leveraging existing risk infrastructure and developing new, climate-specific capabilities. In preparing for climate stress testing, firms must consider team structure, data, models and outputs.
Conducting climate stress tests is a major undertaking for a financial institution. While the risk department generally leads the execution of the test, other teams in the firm are critical to its successful execution. Associates in business line functions must provide insight into customers and evaluate potential business impacts of different scenarios. Economics teams must assess scenario variables and make assumptions to adapt them to the circumstances of the organization. Senior management should be held accountable for test results and for promoting strong climate risk governance. Overall, the firm should invest in enhancing climate knowledge and work to integrate climate risk considerations into new and existing processes.
Despite well-defined roles and responsibilities, successful execution requires good data. The data needed for climate stress testing fits into two categories: traditional financial data and climate data. Traditional financial data is already needed to conduct existing stress tests and evaluate portfolio and client risks. Climate data is generally less integrated into institutional processes. Some climate-related data will come directly from landscapes and provide high-level details on physical risks and transition routes. However, for physical risks, firms will need to work closely with clients and data providers to closely assess the diverse physical threats facing specific assets over different timeframes. For transition risks, firms must be able to measure customer emissions and evaluate customer transition plans.
A central part of climate stress testing, and other forms of climate scenario analysis, involves converting climate-related factors into financial impacts. For physical risks or infection risks, the exercise involves identifying climate-related risk drivers, integrating them into financial risk models, and generating losses and other outputs. Existing stress test models can be a useful starting point for considering the relationship between financial risks and losses. However, firms must often develop or deploy specific climate risk models to take in climate stress test scenarios and produce portfolio losses. Depending on the nature of the test, a wide range of models can be applied, from risk rating scorecards for individual counterparties to econometric regression for portfolio-level default rates.
Interpretation of results
Climate stress testing involves collating model results to generate a perspective on a firm’s overall climate risk. As such, the results of the test include both a quantitative assessment on climate losses and a qualitative strategic plan of the firm to manage its climate risks. While the purpose of these outputs is to meet regulatory requirements, they also have other important applications. Stress test outputs can be used to enhance risk management practices and inform the setting of firm-level risk appetites. The results can also be used to develop new business strategies to capitalize on climate opportunities. Outputs can also improve customer 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. The new tests may have additional scenarios and risk types and may have capital or compliance implications for insufficiently prepared firms. The new tests mean rising expectations for financial institutions. However, firms will also gain insight into their climate risk and will be better prepared to thrive in a changing world. Finance Initiative of the United Nations Environment Program (UNEP FI) has developed a comprehensive guide To help institutions understand the nature of climate stress testing and prepare them to execute stress testing effectively. That resource can be found here.