Climate Stress Testing and Scenarios

Scenario analysis is an increasingly important part of financial institutions’ efforts to manage climate-related financial risks. Scenario analysis helps financial institutions ensure their strategy and business models are resilient under future climate and economic scenarios.

Internally, scenario analysis can be a crucial tool to test the resilience of strategies to different climate pathways, and can help define risk appetite at a client and portfolio level.

Externally, supervisors expect financial institutions to use scenario analysis over multiple time horizons to inform their strategy and business planning and determine the impact of climate-related financial risks that might arise under different scenarios.

Climate scenarios typically combine a range of climate-related environmental variables, make several modelling or analytical choices and then aggregate this together with a set of assumptions and a narrative.

Macro-economic variables – such as GDP and interest rates may be related to climate-related variables such carbon prices, extreme weather indicators and other environmental outcomes.
Modelling choices may touch on the time horizon, the time steps or coverage of climate-related risk factors.
Assumptions would relate to behaviours of all economic agents, the future of technology, policy, timing and more.

Towards a Climate Scenarios Framework

However, selecting and interpreting scenarios can be challenging for financial institutions as they perform climate risk analysis.

They are largely dependent on third-party scenarios, while expertise in these models and scenarios sits predominantly in the academic community.

Available scenarios may not capture the full breadth of scenario narratives and granularity and could potentially be misused within risk management and climate stress testing.

This could result in financial institutions avoiding scenario results or delaying strategic decisions. Relatively benign results could also be used as a justification for inaction.

This project aims to:

Improve practitioners’ understanding of scenarios to enable appropriate scenario selection;
Identify weaknesses in the models that underestimate the impact of currently evaluated scenarios;
Identify gaps in available scenarios and fill those gaps to provide more relevant scenarios.

Ultimately the project aims to develop a framework for practitioners which will allow them to better understand and interpret inherent assumptions and modelling choices in climate scenarios.

However, selecting and interpreting scenarios can be challenging for financial institutions as they perform climate risk analysis.

They are largely dependent on third-party scenarios, while expertise in these models and scenarios sits predominantly in the academic community.

Available scenarios may not capture the full breadth of scenario narratives and granularity and could potentially be misused within risk management and climate stress testing.

This could result in financial institutions avoiding scenario results or delaying strategic decisions. Relatively benign results could also be used as a justification for inaction.

This project aims to:

Improve practitioners’ understanding of scenarios to enable appropriate scenario selection;
Identify weaknesses in the models that underestimate the impact of currently evaluated scenarios;
Identify gaps in available scenarios and fill those gaps to provide more relevant scenarios.

Ultimately the project aims to develop a framework for practitioners which will allow them to better understand and interpret inherent assumptions and modelling choices in climate scenarios.

Publications

An Integrated Credit/Climate Scenario Approach Combining Firm-Level Climate Sensitivity with Climate Volatility Add-Ons

This paper published by Z-Risk Engine (authored by CGFI Associate Fellow Dr Scott D. Aguais) presents a detailed approach for developing climate risk stress test scenarios that applies firm-level climate physical-and transition-risk sensitivities and introduces credit risk shocks into climate risk modelling.

An input–output sensitivity analysis of climate–economy integrated assessment models

This paper analyses the underlying interactions between input and output variables of three process–based climate–economy integrated assessment models according to a standardised sub- set of social and economic input variables, and how they contribute to variability in scenario outputs.

The challenge of climate risk modelling in financial institutions – overview, critique and guidance

CGFI Chris Cormack and Gireesh Shrimali discusses the various general issues with climate risk modelling in financial institutions, including data availability and quality, model uncertainty, and integrating climate risks into risk management frameworks.

Toward A Framework For Assessing And Using Current Climate Risk Scenarios Within Financial Decisions

This CGFI discussion paper analyses empirical findings and current best practice to review the adequacy of climate risk scenarios for financial decision making.

A re-evaluation of the financial risks of the net zero transition

This paper examines the potential impact of climate change on financial risk and the uncertainty surrounding the outcomes of different mitigation scenarios. The authors use a consistent climate stress test model to evaluate the effect of three possible net zero scenarios on companies' valuations and financial investments.

TRISK - A Climate Stress Test for Transition Risk

This paper develops a climate stress test that translates climate transition risks affecting individual firms and economies to shocks affecting the financial system. As part of this, we present a forward-looking risk measure - TRISK - which is the expected loss of a financial institution given the uncertain materialisation of a transition stress scenario.