By Peter Plochan, EMEA Principal Risk Management Advisor at SAS.
Climate stress testing is emerging as a critical tool in the financial industry, marking a new era of risk management that focuses on understanding and preparing for the complex impacts of climate change.
Traditionally, stress testing in finance has centred on economic indicators including interest rates, inflation, and liquidity metrics, to gauge an institution’s resilience. However, as the realities of climate change intensify, financial institutions are expanding their approach by using climate stress testing to receive a more comprehensive and quantifiable view of potential vulnerabilities.
Beyond conventional measures
Banks’ climate stress-testing policies are increasingly designed to assess both physical and transition risks associated with climate change.
Physical risks involve direct and indirect impacts from climate related events like floods, wildfires, and extreme weather, which can impair assets and disrupt operations of banks and their customers. With global warming the frequency and severity of these events is increasing and so does the materiality of physical risk for banks, their portfolios and their customers.
Transition risks on the other hand involve the financial implications of shifting toward a low-carbon economy, including regulatory changes, carbon pricing, and shifts in market demand that may devalue high-emission assets or products of banks’ customers. Integrating both types of risks allows banks to gain a comprehensive understanding of how climate change could impact various areas of their portfolios and operations.
As climate-related risks grow more frequent and severe, they increasingly threaten asset values, revenue streams, and financial stability. Financial institutions now rely on sophisticated models to quantify these impacts and to make projections that extend over decades, far beyond typical business cycles.
Future changes and developments of Climate are not defined or carved in stone anywhere and climate scientists struggle to form a view on the expected future evolution of our Climate. Thus banks need to work with various alternative climate scenarios which represent pathways of how climate is likely to evolve over the coming decades and banks need to be prepared to replace the scenarios with new ones according to the progress in Climate Science.
For example, the Net Zero scenario describes a state of future where the decarbonisation effort globally succeeds in reaching net zero emissions by 2050. According to Climate Science this is required for stabilising global warming at 1,5 – 2 degrees Celsius compared to pre-industrial levels, in line with The Paris agreement.
On the other hand, a Hot House world scenario would represent a pathway towards a future where our transitioning efforts fail, and the global warming levels reach 3 – 5 degrees by 2100 and do not stop there. There is not a future without climate risk – each future scenario represents a different combination of transition and physical risk, thus impacting different parts of bank portfolios
Climate stress testing enables these institutions to simulate a range of such climate scenarios, analysing how shifts in policy, market dynamics, or environmental conditions might affect their portfolios. Rather than serving solely as a compliance measure, climate stress testing has become a strategic tool, equipping financial institutions to anticipate climate-related disruptions and proactively adapt their risk management practices and portfolio allocations in an uncertain and evolving landscape.
To help achieve this, banks are using advanced and dedicated forward looking simulation capabilities to enhance climate stress testing by analysing vast datasets, modelling complex climate scenarios, and assessing financial risks linked to climate change. Increasingly, banks are exploring various portfolio decarbonisation pathways allowing them to better respond to the transitioning trends toward a decarbonised economy. Transition planning is a mandatory element of all major sustainability disclosure regimes around the world. Furthermore in some jurisdictions, regulators already require banks to adopt net zero portfolio financed emission targets by 2050 that are in line with The Paris Agreement.
These portfolio decarbonisation and transitioning simulations processes require banks to apply similar techniques, data and scenarios as used in Climate stress testing.
At the same time banks have been already performing the normal BAU stress testing for years and have to continue doing that even more, given the unprecedented volatility in the global economy caused by things such as increasing geopolitical crises.
A big task and opportunity at the same time that lies ahead for many banks, is how to bring all these various forward-looking simulation processes together in an efficient manner.
By integrating these processes banks can share and leverage the same data, models and underlying infrastructure, and so increase automation and reduce manual handovers. This will enable them to assess more scenarios, generate more insights for better strategies and achieve synergies of scale.
Building resilience
With better insights and portfolio strategies financial institutions can build their resilience by prioritising investments in climate-resilient sectors. Transitioning to greener, more sustainable practices has significant implications for the future viability of assets and revenue generation in banking portfolios. For instance, banks and asset managers are increasingly looking at renewable energy sectors, such as wind and solar power, as stable, long-term investments.
By reallocating funds toward industries that are both environmentally sustainable and likely to remain resilient both in a carbon-constrained and climate-deteriorated future, financial institutions can protect their portfolios from physical risk while supporting a broader transition to a sustainable economy.
Additionally, investments in energy-efficient infrastructure and climate-conscious technology are not only beneficial for the environment but can also offer stable returns as demand for these sectors rises in a low-carbon economy.
In addition to rethinking their investment portfolios, financial institutions can contribute to climate resilience by offering innovative financial products tailored to climate risks. Green bonds, or loans, which are designed to fund projects that address environmental challenges, have gained popularity as a tool for channelling capital into sustainable initiatives.
By offering green loans and bonds, banks can support projects that focus on reducing emissions, building renewable energy infrastructure, or restoring natural ecosystems. These bonds appeal to environmentally conscious investors and create value by funding projects that mitigate climate change impacts.
Banks are also establishing guidelines and policies on data collection and analysis. Climate stress testing relies on diverse data, including emissions data from clients, sector-specific climate impact models, geo-location based information on the current and potential future impact of various climate hazards, and forecasts from climate science.
Looking ahead
Ultimately, climate stress testing is pushing financial institutions to not only adapt to but actively participate in the transition to a sustainable economy. Transition planning and portfolio decarbonisation is no longer a ‘nice to have’ for banks.
As they identify vulnerabilities and adapt strategies for resilience, institutions are not only protecting their own interests but also contributing to a more sustainable global economy. Banks have a significant role to play in promoting climate resilience, from financing green projects to developing new risk management solutions. By doing so, they can support a global shift toward sustainability while safeguarding their own stability in an uncertain future.
