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 that societies will face in the years to come. Financial actors are increasingly trying to understand the unique risks and opportunities of climate change. The financial supervisory authorities have also taken note of this. Like the Federal Reserve (Fed) Governor Lael Brainard, “climate change and the transition to a sustainable economy are also risks to the stability of the entire financial system”.
Stress testing: a regulatory tool
After the global financial crisis, many financial regulators realized that systemic financial risks had been overlooked and that those risks had ravaged the global economy. Determined to mitigate future financial crises, the regulators tried to ensure the resilience of the financial system and individual institutions to financial risks. Stress tests were a key tool in these risk and resilience assessments. These reviews assess companies under a variety of economic scenarios and take into account their performance and capitalization.
As climate has become a widely recognized financial risk, regulators are creating climate stress tests to better understand the extent and nature of the climate risk. The Dutch Central Bank (DNB) was one of the first central banks to develop a climate stress test. The Bank of England (BOE) and the European Central Bank (ECB) have now developed mandatory audits to assess both short-term and long-term climate risks. The US Federal Reserve recently released a paper on climate stress metrics, and a number of other global regulators have announced plans for stress tests in 2022.
Four Considerations for Conducting Climate Stress Tests
While these tests differ in some ways: specific scenarios used, required granularity of analysis, and types of risk considered, they have some similarities. Most tests try to examine climate risks both qualitatively and quantitatively. The quantitative element typically includes the assessment of losses overall and across different portfolios under different scenarios. It may also include specific counterparty-level analysis to study the climate risks of large customers. The qualitative element focuses on management measures to reduce the climate risk and to take advantage of new opportunities over the course of the scenario. In this narrative, the climate policy, strategies for customer loyalty and the company’s decarbonisation goals can be discussed.
Developing a full picture of a company’s climate risks requires strong organizational coordination. Financial institutions are currently mobilizing resources to meet climate stress test requirements. These requirements include the use of existing risk infrastructure and the development of new, climate-specific capabilities. When preparing for climate stress tests, companies should consider team structures, data, models and results.
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Conducting a climate stress test is a huge undertaking for a financial institution. While the Risk Department typically oversees the conduct of the audit, other teams across the company are critical to its successful completion. Colleagues in business unit roles should provide insights into the customers and assess the potential business impact of the various scenarios. The economics teams should evaluate the scenario variables and make assumptions to adapt them to the institution’s circumstances. Senior management must be accountable for the results of the audit and promote strong climate risk governance. Overall, the company should invest in improving climate knowledge and work on integrating climate risk considerations into new and existing processes.
The right data
Even with clearly defined roles and responsibilities, successful execution requires good data. The data required for climate stress testing can be divided into two categories: traditional financial data and climate data. Classic financial data is required to carry out current stress tests and to assess portfolio and customer risks. Climate data are typically less well integrated into institutional processes. Some climate-related data comes directly from scenarios and provides detailed details on physical risks and transition paths. However, when it comes to physical risk, organizations need to work closely with customers and data providers to granularly assess the various physical hazards that certain assets are exposed to over different time periods. In the case of transition risks, companies must be able to measure customer emissions and evaluate customers’ transition plans.