Stress tests for climate risk

Why stress tests need to be adjusted for climate risk

Stress testing for the transition to a low-carbon economy is a new and rapidly evolving area. Transition shocks will likely emerge as the global economy moves away from industries reliant on non-renewable resources, such as the coal industry. Financial institutions could incur losses on exposures to such firms with business models not built around the economics of low carbon emissions. These firms could see their earnings decline, businesses disrupted, and funding costs increase due to policy action, technological change, and shifts consumer and investor behavior. Risks can materialize especially if the shift to a low-carbon economy is abrupt (as a consequence of prior inaction), poorly designed, or uncoordinated globally. Going forward, a key next step in developing stress tests for transition risks will be to capture “second-round” effects—in which a decline in asset prices leads to fire sales, which further depress asset prices, generating a vicious cycle and an amplifying mechanism for an initial shock.

Source: “The Green Swan: central banking and financial stability in the age of climate change”  – BIS
Assessing Climate-Change Risk by Stress Testing for Financial Resilience
By: Tobias Adrian, James Morsink, Liliana Schumacher – IMF

Climate related stress tests for EU banks

Alexander Lehmann, in this policy brief, suggests certain steps EU supervisors should follow in order to develop climate stress tests for European banks.

• Develop possible scenarios. The Bank of England anticipates three scenarios: timely policy measures that will limit global temperature rise to below 20C; delayed action only in ten years’ time which ultimately succeeds in a similar limitation, though at that point proves highly destabilizing; and no significant policy action which results in substantial temperature increases, and sharp increase in physical risks;
• Set a realistic approach to stress testing especially since there is a lot of uncertainty over what these climate risks might be. In particular, the assessment of these risks should focus on credit losses, and not turn into a comprehensive assessment of the health of a financial firm, its income and capital. At the beginning at least, these tests should not be the basis for capital requirements at bank level.

Climate risks to European banks: a new era of stress tests
By: Alexander Lehmann – Bruegel