The use of stress tests is an important step forward in dealing with climate risks as these tests are useful for sizing, even if only approximately, potential impacts of climate risks.
Global and national financial
authorities are increasingly taking action to require the financial
industry to assess and manage climate risks. To this end, they have
launched stress tests for banks and more exercises are planned for the
near future.
This paper discusses the challenges that emerge when trying to adapt
traditional stress tests to banks' climate-related risks. These
challenges relate to: (i) data availability and reliability; (ii) the
adoption of very long time horizons; (iii) uncertainty around future
pathways of key reference variables covering physical risks (eg floods,
temperature increases and rising sea levels); and (iv) uncertainty
relating to transition risks (eg changes in climate policies,
technologies or consumer preferences). Modelling approaches also need to
be revised to include a climate risk component, and to allow for finer
sectoral and geographical breakdowns.
Drawing on three recent stress tests for climate risk, the paper reviews how these challenges have been addressed in practice.
The paper concludes with some reflections about the possible
implications for prudential requirements of addressing climate risk.
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