Henk Jan Reinders Dirk Schoenmaker Mathijs Van Dijk : Given the complexity of the link between climate shocks and financial sector outcomes, the authors argue that current methods have several key limitations that may lead to significant underestimation of potential financial sector losses.
Central bank concerns about climate change are on the rise, and a plethora of new methods have been developed to assess the impact of climate-related shocks on the financial sector. This column reviews current climate risk stress test methods and identifies six types of climate shocks and four types of modelling approaches.
Climate change can potentially cause highly adverse shocks to the financial sector. Central banks and other policy institutions increasingly rely on a host of newly developed climate risk stress-testing (CRST) methods to assess these potential effects. While traditional financial risk assessment methods typically assume that the future will be similar to the past, climate change is likely to lead to unprecedented and often detrimental changes in a broad set of regions and economic sectors over a long period of time. This implies a need for forward-looking risk assessments, based on those future outcomes that are potentially most detrimental. We identify six types of climate-related shocks that are relevant for climate risk assessments: abrupt transition, gradual transition, hot house world, climate-related disaster, 'green swan’ events, and Minsky-type shocks. Figure 1 provides an overview.
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