SUERF's Walther: Climate stress tests: Are banks fit for the green transition?
24 March 2023
So far, climate stress tests are declared learning exercises with no direct implications for capital requirements. However, supervisors are urging banks to set up a comprehensive climate risk management.
Climate stress tests have emerged as a key tool for looking into the financial system’s vulnerability to climate risks. Banks’ exposure to climate risks stems from (1) physical risks that are closely related to geography, and (2) transition risks mainly from loans to carbon-intensive sectors. Exercises by the ECB and BoE suggest that banks’ credit losses in a disorderly transition would be higher than in an orderly transition scenario, and even higher in a “hot house world” with unabated global warming. Banks would be able to absorb climate-related losses due to strong capital buffers. Results are subject to data limitations and modelling constraints.
Financial system vulnerabilities to climate risks
Climate change has moved high on the agenda of financial institutions, regulators and supervisors. The looming risk of unabated global warming has once again been brought to the fore by last year’s heatwaves, droughts and floods across the globe. Over the last 50 years, the number of climate-related natural hazards has increased fivefold, and the associated economic losses have grown by a factor of eight (Chart 1).
1 Losses and damages from climate change were also a key issue at the recent COP27 climate conference, resulting in an agreement to install a fund to compensate the most vulnerable countries.
Chart 1: Climate-related losses growing significantly
* in 2018 prices
Sources: WMO (2021), Deutsche Bank Research
Against this backdrop, banks and financial supervisors have started to look at the resilience of the financial system towards climate risks. Given the long-term nature of climate change, climate stress tests or scenario analyses have emerged as a key tool for such assessments. A recent survey among supervisory authorities
2 counted 67 completed, ongoing or planned climate stress tests. For example, in September 2022, the Fed announced that six large US banks will participate in a pilot climate scenario exercise this year. In Europe, the latest example is the ECB climate stress test (CST) conducted in the first half of 2022.
This paper will take a closer look at climate stress tests with a focus on the 2022 ECB CST, but also include
scenario analyses from other major supervisory authorities. Comparing these exercises yields key findings about banks’ exposure to climate risks as well as potential implications for financial stability.
3
Banks’ exposure to climate risks
Global warming as well as measures to address it involve two types of climate risks for financial and non-financial companies:
- Physical risk stemming from changes in weather and climate. This includes acute risks such as floods, droughts, heatwaves and wildfires as well as chronic risks like rising temperatures and sea levels.
- Transition risk arising from (i) changes in climate policies, (ii) emergence of new technologies and increasing affordability of low-carbon technologies, and (iii) changes in investor and consumer preferences...
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