Financial Institutions Factor Transition Risk into Climate-Related Stress Testing:
Climate change has become a major strategic issue for financial institutions around the world as concerns arise over loans, investments, or insurance for companies not taking steps to move to a low-cost economy. Research shows that in the five years since the Paris Agreement, only 60 of the world’s largest banks have funded $3.8 billion in fossil fuels . As stakeholders continue to focus on sustainability issues, it is essential that financial institutions better understand the climate. – correlate with what they are dealing with.
Climate change can pose physical risks from adverse weather events such as drought, fires, and hurricanes, as well as transition risks from policy changes, market dynamics, technological innovation, and consumer confidence. For banks, transition risks can lead to a revaluation of a wide range of assets if business models do not align with the energy transition, putting pressure on corporate profits. In addition, constant issues in investor sentiment, consumer demand, and social expectations can significantly alter a bank’s credit and investment strategies. Transition risks can also affect the insurer’s liabilities and assets. The transition to a low-carbon economy can influence costs by reducing the premiums associated with a change in business operations, for example, if electricity activities are interrupted.
In addition, significant technological advances could lead to losses for insurers’ holdings in financial assets for carbon-intensive industries if prices do not fully reflect risks. From an investment perspective, there are also the risks of carbon-intensive goods at the wrong prices.
Test the resilience of financial institutions against climate risks
Macroeconomic stress testing became more important after the 2007-2008 financial crisis, which used forward-looking scenarios to understand how an organization could be affected by adverse market conditions. The increasing threats to climate change have sparked a strong interest in developing stress tests to assess the risks to financial stability associated with the transition to a low-carbon economy. Some central banks are even planning to conduct climate change stress tests by 2021. For example, the Bank of England is using its 2021 forecast scenario to test the resilience of current business models at leading banks and insurers. dare to expand the necessary adjustments in the coming decades to keep the system resilient.
Challenges to include weather risks in stress tests
However, stress tests for climate change differ significantly from existing macro stress tests and present a number of challenges:
• The lack of high-quality historical data makes it difficult to model the interaction between climate, macroeconomics, and industries and requires data gaps to be filled with reasonable, defensible, and transparent assumptions.
• A long time horizon for testing climate stress measurements between 30 and 50 years, instead of the typical nine quarters for macroeconomic stress testing, requires a methodological transformation to define a set of reasonable financial assumptions that can be used up to this long term. used.
• At the same time, as the effects of climate change risks manifest more rapidly, it is necessary to integrate modeling skills that support less orderly transitions in the short term.
• The need to monitor carbon emissions by energy type, direct or indirect emissions, and country of origin requires detailed sectoral data.
• Different tax systems by country require an understanding of specific policies and the ability to reflect them in the analysis.
• Different effects on the production of goods and on the elasticity of demand due to price fluctuations due to the increase in the CO2 tariff, require the use of scientific/integrated models that take into account the energy transition and the variation in energy demand by country. / region.
• Integration of portfolio-level and related credit analysis mechanisms