19/07/2021 | BIS
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. 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.
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.