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Climate Stress Test Insights

How can climate-informed stress testing support a more resilient global economy and society?

This was the question that was recently discussed during the COP26 event: Climate-Informed Stress Testing for the Financial Sector, hosted by the UK Centre for Greening Finance and Investment and the UK Met Office with the Bank of England and the European Central Bank.

Building upon the Network for Greening the Financial System (NGFS) climate scenarios, the Bank of England published details of their first Climate Biennial Exploratory Scenario (CBES) in June 2021. The scenarios were derived in order to assess financial institutions’ resilience to a number of different climate scenarios. The exercise explores the resilience of the UK’s largest banks and insurers to the physical and transitional risks associated with climate change.

The CBES consists of three scenarios that explore the two key risks of climate change, transitional risks; the risks that arise as the economy moves from carbon-intensive one to net-zero emissions, and physical risks; risks associated with higher global temperatures likely to result from taking no further policy actions.

The three climate scenarios are early action, late action, and no additional action.

  • Early action: transition to net-zero economy begins in 2021 with a gradual increase in carbon taxes and policies to reduce emissions. Global carbon dioxide emissions reach net zero and global warming is limited to 1.8℃ by around 2050.
  • Late action: Implementation of policies to drive down emissions are delayed until 2031 and as a result, the transition is more disorderly but global warming is limited to 1.8℃ by 2050.
  • No additional action: No new climate policies are introduced causing the realisation of physical risks. Global temperatures increase, sea levels rise, and extreme weather events increase in regularity and severity including floods, droughts, wildfires, cyclones etc.

The European Central Bank (ECB) has recently published their first climate stress test results with the key message that orderly transition is the best option since the short-term costs are more than compensated for by the medium to long term gains. Although any transition, however orderly or disorderly, is always better than the no-action scenario for two reasons.

  1. There are benefits of investing in green technology. Once the initial costs are overcome efficiencies are gained.

  2. The physical risks of climate change, if left unmitigated, increase nonlinearly with time. There is also a point where certain physical changes in the environment are irreversible.

    Many more central banks have committed to doing climate stress tests and regulators will be inviting financial institutions to undertake their own climate stress tests in the near future.

     

Climate stress tests pose unique modelling challenges to the financial sector. Financial institutions cannot look to the past for data to model the impact of the transitional and physical risks of climate scenarios. The multidisciplinary nature of the problem results in extra complications since there are obvious difficulties in bridging the gap between climate modelling and macroeconomic and financial modelling. Whilst much work has already been done by the NGFS and central banks to overcome these issues, implementation of the climate scenarios within an institution’s stress testing framework is far from trivial.

MIAC is continually looking for ways to help clients understand the risks and to identify opportunities that arise from climate scenarios. For more information on how MIAC can help your organisation get ahead of the unique modelling and data requirements for climate stress testing please contact us.