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.