Finance • Authorities are using stress tests to assess financial actors’ exposure to climate risks

To assess the climate risks financial actors are exposed to, market and other authorities are increasingly experimenting with an extension of a widespread financial practice: stress tests. The first systemic tests yield initial observations as to the exposure of institutions in different parts of the world.

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Climate Chance Observatory | Finance For Tomorrow

Authorities are using stress tests to assess financial actors’ exposure to climate risks

Given the learning objectives of the pilot tests and their limitations in terms of data and methodology, none of the prudential climate tests conducted to date will be used to set minimum capital requirements (‘Pillar I’).

With its 2022 climate stress test, the European Central Bank (ECB) stands out as the authority that has taken the exercise furthest : it will take under consideration the qualitative results of its stress test and its ongoing review of how banks integrate climate and environmental risks (Supervisory Review and Evaluation Process, SREP).

These reflections could feed into Pillar II requirements emerging from bilateral dialogue with banks, an outcome most likely to impact those institutions with persistent deficiencies.

However, there are still several major areas where considerable work remains before climate stress tests become a full-fledged supervisory tool:

  • Engaging in strategic thinking about climate risk: the results of climate stress tests can be used from a strategic perspective, as they provide a long-term view of the institution’s vulnerabilities to climate risk and can help to strengthen financial stability in the short term.
  • Accessing and managing data: climate stress tests are constrained by uneven data availability/coverage, poor quality, low granularity, limited comparability and standardisation as well as poor integration with financial processes. 
  • Providing human and financial resources to carry out these exercises within institutions: the acquisition of key climate-specific knowledge and skills within institutions is essential to effective exercise design and execution.
  • Developing scenario analysis capacity: the ECB’s ‘bottom-up’ approach, which requires institutions to analyse the impact of a scenario based on an internal model of their own and in coordination with authorities, appears to be the preferred solution for stress tests going forward.