If done well, climate stress testing brings rewards beyond regulatory compliance. To obtain useful results, however, firms need to master an arsenal of advanced techniques combining disciplines as different as macroeconomics and catastrophe modeling.
1. What is climate risk?
Climate risks are the dangers to which the global economy is exposed as a result of the climate emergency. They are generally divided into two main categories:
Physical risks are caused by the direct consequences of global warming. We are already seeing gradual, chronic effects such as rising sea levels. But the frequency of acute events such as storms and wildfires that are harder to predict is also increasing.
Transition risks are caused by the shift toward a sustainable economy, including policy changes and technological breakthroughs. In scenarios where the transition occurs sooner, for example, where carbon taxes are hiked dramatically, transition risks are predominant. Where the transition is late, with global temperatures rising unchecked, physical risks take center stage.
2. Why should financial institutions care about climate risk?
Regulation and reporting are the primary drivers of most stress-testing exercises. As the guardians of economic stability, regulators require financial institutions to carry out regular stress-testing exercises. Regulators also play an increasingly important role in reigning in climate change. Central banks, with the UK’s PRA and the ECB in the vanguard, are already rolling out climate stress tests. These have a dual purpose. First, they assess the financial sector’s resilience to climate change. And second, they estimate the impact that individual firms have on the climate.
Risk and business management
Climate stresses will have a tangible impact in the coming years, so insights gleaned from scenario analyses can also be important for managing risk and steering the business. Firms can estimate the emissions associated with their portfolio under a given scenario to see how far they are from a 1.5-degree net-zero pathway. But it doesn’t stop at damage limitation; scenario analysis can also boost returns by helping identify future growth areas under specific scenarios.
3. How does climate stress impact the balance sheet?
Assets are impacted by both physical and transition risks. The precise mechanism of transmission depends on the asset class and the class of risk. A full assessment must incorporate everything from the impact of floods on real estate to the impact of carbon taxes on energy costs.
Insurance liabilities are also difficult to model well. Insurers often have a good idea of the physical impact by using existing catastrophe models. But our understanding of the impact of transition variables, such as the decarbonization rate of different industries, is only now emerging.
Own operations are not highly material for most financial institutions, but nevertheless, the impact of climate risk on the bank’s buildings, people and infrastructure should be assessed. This can also extend to the upstream effects of suppliers, for example.
4. Three steps to measure climate stress
Climate stress testing – or scenario analysis – has its roots in the macroeconomic stress tests that were mandated by regulators in the wake of the 2008 financial crisis. The idea is deceptively simple. Come up with a severe, but plausible future scenario and figure out what would happen to your institution if that scenario were to play out.
Scenario generation is the starting point for any stress test. The scenario is the set of variable pathways that represent a particular hypothetical outcome. It is a difficult economic and computational problem to produce a consistent scenario of financial, macroeconomic and physical variables. The problem is made even more challenging by the length of the scenario. Climate risk scenarios span up to 50 years, compared to three to five years for traditional stress testing. Regulators provide narratives and sometimes variable pathways, but usually the institution will need to fill in the gaps. And sometimes a bespoke scenario might prove more illuminating.
Impact assessment is where we find out how the parts of a particular institution would fare if a given scenario were to occur. The calculation is built starting from the individual components of an institution’s balance sheet. The exact approach then depends on the asset or liability class in question. Take a corporate bond as an example. The impact of events like wildfires on the corporation’s physical assets such as factories and inventory is one part of the story. But this must be combined with transition risk impacts on the cost of energy, raw materials, and labor.
Metrics are the end point of any stress test. They tell us how well the institution fared under the scenario. In traditional stress testing, metrics of financial resilience such as the CET1 ratio (a measure of capitalization) are the go-to metrics. For insurance companies, solvency ratios play a similar role, but are more complex to calculate. Climate stress testers are certainly interested in these metrics, but they are also concerned with the amount of carbon that an institution pumps into the atmosphere throughout its journey.