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Climate Risk, Scenario Analysis and Stress Tests

What is Climate Risk?

Climate risk, very broadly, refers to negative consequences of climate change. In the financial world, climate risk falls into two main categories:

  1. Physical
  2. Transition

Physical risk is the risk of tangible harm from climate change. This could include property damage, insurance costs and business disruptions caused by climate-related events such as increasingly frequent and severe floods, droughts, and fires. Physical risk will generally become more pronounced the less we act to reduce global greenhouse gas emissions (GHG) and limit global warming.

Transition risk is the risk involved with taking action on climate change, including reputational, regulatory and policy risks. For example, carbon pricing policies or the growing preference — and associated taxonomies to support this — amongst investors for firms with low (or lowering) carbon operations can cause asset depreciation in high emitting sectors. These policies or changing attitudes also cause a general disturbance to the economy, particularly for industries that are not currently compatible with a low- or zero-emissions world. This does not mean that all knock-on effects of acting on climate change will be negative, some will be positive as new industries will be created while others will evolve and grow. In a sense, and at a global scale, transition risk is self-imposed but can help lower the overall severity of physical risk.

As the financial world comes to accept these risks, new processes, standards, and quantitative techniques are being developed to evaluate them systematically so that prudent decisions can be made. Some examples of these are scenario analysis and climate stress tests.

What Is Scenario Analysis?

Scenario analysis, in its most general form, is a very common practice. It is the consideration of different future states of the world and how they may affect an area of interest. The analysis is usually performed to evaluate risk and helps to make decisions now that will make life easier in the future by implementing risk mitigation strategies. Put more simply, a scenario analysis is a what-if process. That is, asking oneself what could happen if certain events occur.

The financial world is very familiar with scenario analysis. It is commonly used to evaluate how future events could impact a financial institution’s interests such as the valuation of a portfolio or the health of the economy more broadly. In the context of climate risk analysis, scenario analysis looks at different states of climate change and climate policy. Scenario analysis can bring structure and helpful limits to the possible future states of the world. That is, it is helpful, and comforting, to know what are the best- and worst-case scenarios of something moving forward. The scenario analysis process also promotes proactive (rather than reactive) decision making.

What are Climate Stress Tests?

Climate stress tests build on the type of more stringent stress testing that became popular following the 2008 financial crisis. This type of financial stress testing generally refers to the process of using scenario analysis to examine the financial resilience of an entity under adverse conditions.

Simply put, it is intentionally modelling a stressful event to determine its impact. For example, when applying for a mortgage you may be subject to a stress test that determines your ability to withstand rising interest rates and the implied increase in your monthly mortgage payments.

Climate stress tests use scenario analysis to evaluate the effects of intentionally designed conditions, which may add “stress” (i.e., additional risks) to potential outcomes. However, the stressful event originates in different states of climate (caused by varying levels of climate policy), not the economy. This does not mean that economic conditions are not also considered because different climate states — be it through physical or transition risk — can affect the economy.

The Current State of Climate Stress Tests

Climate risk stress testing is a growing field and collaborative efforts are being employed in full swing. Since 2017, regulators from around the world have been working on sharing best practices for climate-related risk management within the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), which by February 2022 had grown to 108 members and 17 observers. Central banks and regulators in Canada, Australia, France, England, and the Netherlands have begun performing climate stress tests, or have announced their intention to do so. 1

The European Union (EU) has recently published its economy-wide climate stress test. This EU-wide exercise was one of the first to examine not only the risks associated with climate change (both transition and physical) but also how they interact. The analysis tested the impact of these risks on four million firms worldwide and 1,600 euro area banks under three different climate policy scenarios. The report’s findings will also inform the European Central Bank (ECB)’s 2022 supervisory stress tests where they have chosen climate risk as their specific topic of interest. 2

The Bank of Canada (BoC) and Office of the Superintendent of Financial Institutions (OSFI) also recently released a report that evaluated climate risk using scenario analysis. The report evaluated transition risk but left out physical risk, at least during this pilot project. The report also built the capacity of participating financial institutions to do climate transition scenario analysis and supported the Canadian financial sector in improving their assessment and disclosure of these climate related risks. 3

Actors working to analyze climate risk have frequently cited gaps in climate data as a hindrance to the full and proper evaluation of risks present. For example, consistency and comparability of firms’ greenhouse gas (GHG) emissions is currently lacking, leading some regulators to make such reporting mandatory. The private sector is also getting involved through either conducting these risk tests themselves, offering climate risk analysis services, or data packages to help fill some of the current data gaps. In fact, having companies provide a scenario analysis that evaluates the company’s exposure to climate risk is one of the recommended disclosures of the Task Force on Climate-related Financial Disclosures (TCFD), which is an industry-led entity that was created in 2015 by the Financial Stability Board (FSB) to provide information to improve financial processes such as investment, lending, and insurance underwriting.4 For more information see the ISF primer on disclosures.

Climate Stress Test Findings

The major authoritative reports from BoC/OSFI and the ECB have several main takeaways. In the case of the BoC/OSFI report, it found that delayed action can cause greater risks and impact to the economy, while the ECB report also concluded that there are clear benefits to acting early. According to the ECB report, physical risk, compared to transition risk, will likely be more prominent in the long run, especially without policies to transition to a greener economy. Climate change represents a major source of systemic risk, “particularly for banks with portfolios concentrated in certain economic sectors and, more importantly, in specific geographical areas”. Every sector will need to contribute to the transition, however, the BoC/OSFI analysis showed that “significant negative financial impacts emerged for some sectors (e.g., fossil fuels) and benefits emerged for others (e.g., electricity)”. Macroeconomic risks are also present, particularly for carbon intensive commodity exporting countries like Canada.

Lastly, the BoC/OSFI report found that financial institutions were generally in the early stages of building climate- related risk assessment capabilities and that there was a need for both standardized methodologies and improved availability of climate-related data. These reports create a strong foundation for climate risk stress testing as they provide a set of reusable climate scenarios and methods for proper analysis. The reports also highlight the real economic impacts of climate change. Overall, the growing use of climate stress testing is a welcome addition to the set of tools needed as we transition to a net-zero economy.

This series explores the foundations of sustainable finance, one of the most important emerging fields of our time. Sustainable finance aligns financial systems and services to promote long-term environmental sustainability and economic prosperity.