The Rise of The Climate Stress Test

A climate stress test is a way of analyzing entities based on their risks related to climate change. The concept has gained traction in the last few years, as more central banks, and corporations want to be compliant with climate initiatives. Climate change and climate-related risks have increasingly gained prominence as a matter of concern across financial markets. In a way, they pose a danger to the stability of financial institutions and the global financial system as a whole. This has led regulators and market intervenients to address the challenges of climate risk through climate stress tests.

So far central banks such as the Federal Reserve (FED), and the European Central Bank (ECB) have undergone climate stress tests. The Bank of England for instance is requiring climate stress tests to banks and insurers in the region. Although the repercussions of failing such a test are not material for now. In the future, central banks are considering reviewing capital requirements based on the climate stress tests results. For financial institutions that do not comply with the requirements of climate stress tests.

Understanding climate change stress testing

In order to assess an entity’s risks related to climate, there are several aspects that need to be considered. It falls under three main categories, such as physical risk, transition risk, and liability risk. 

Physical risk is directly related to weather events that could pose a threat to an institution's sustainability. The test is therefore conducted, trying to assess how an extreme weather event could be detrimental to the entity.

Transition risk is dependent on an institution’s ability to comply with policy and regulations surrounding climate change. Most notably, institutions need to be compliant with the Paris agreement. The Paris Agreement was signed with the goal of reducing emissions.

Liability risk is much more difficult to estimate. It focuses on trying to determine if an entity would be liable to legal action due to climate concerns. Although this risk is currently low, in the future we could see an emergence of legal proceedings related to this matter.

Not all entities are prone to these three risks, however, a climate stress test entails the analysis of all. In order to be compliant, entities will have to demonstrate that their climate-related risks do not pose a threat to their sustainability. In the future financial institutions will be obliged to reduce their climate-related risks, and to lower their physical and transition risks at all costs.

What is the goal of climate stress tests?

The purpose of climate change stress testing is to determine the impact of climate-related risks on financial institutions. This impact is analyzed across all sectors and geographies. Using different models, entities will be put under various stress scenarios. 

If the results of the test are not enough to be compliant, these financial institutions will need to address these issues. As of now, climate stress tests do not have any direct impact on institutions. However, it is expected that in the future climate stress tests could directly determine the cost of capital and capital requirements.

The main goal of climate stress tests is to make sure that every entity is doing what it can to fight climate change. Being able to implement sustainable practices in their business model, will be an advantage for the planet and for the stakeholders. The main goal of the climate stress test is to help institutions to lower the climate risks they are exposed to. Eventually rebalanced their portfolios, and adjusted their strategies based on this. Even if some financial institutions do not want to comply with these new mandates, at some point they will be forced to integrate climate risk management into their business model.

Factors influencing climate stress tests 

Traditional stress tests for financial institutions are done based on quantifiable metrics. Climate stress tests on the other hand are much more prone to interpretation. Any climate-related risks cannot be quantified in the same way. For that reason, it poses not only a challenge to those conducting these tests but also for institutions that might not directly perceive the risks at hand.

Data 

A climate stress test is based on the possibility of extreme weather events that might impact an institution. Due to the nature of such events, it is incredibly hard to estimate exactly what will happen and how it will happen. This can directly influence the data collected, and the results may be skewed.

Impact on businesses

The business outlook varies greatly. For that reason, it is difficult to foresee the climate risks associated with a certain company. Different sectors will also be impacted in different ways. The same way that different regions will have different consequences. This makes it difficult to assess the different outcomes of every business. 

Time

When it comes to climate stress tests, time is an important factor to consider. However, due to the unpredictability of climate risks, it becomes very challenging to accurately model a timeframe for such occurrences. This is why it is extremely difficult to factor it into a model that accurately portrays the future.

Bottom line

Climate stress tests are here to stay. Although this is a relatively new concept, it is slowly being adopted worldwide. Institutions will allocate more and more resources to reduce their climate risks. It is a new area that is booming and soon could have a direct impact on businesses worldwide.