How to improve stress testing for climate change

The challenges arising from the fundamental uncertainty of climate risks and impacts

Climate risks that can profoundly impact financial markets are generally classified into two primary categories: physical risks, caused by changing climate conditions such as temperature variations and weather patterns; and transition risks, associated with the shift towards a low-carbon economy.

While it is widely acknowledged that fundamental uncertainty remains about how the world will respond to climate change, and the extent of global temperature rises, significant progress has been made in recent years to identify a range of plausible temperature pathways, depending on how and when the world transitions to a low-carbon economy. Once these pathways are translated into climate scenarios, they have been effective in illustrating a wide range of anticipated climate risks.

However, the key characteristic of climate risk is that its fundamental uncertainty also applies to the severity of the associated impacts. In the context of physical risks, as highlighted by the IFoA, there is growing evidence that the planet is warming faster than previously expected, which increases the risk of triggering multiple climate tipping points. This, in turn, could lead to a higher frequency of events that result in catastrophic losses.

For transition risks, ongoing uncertainty surrounds the development of new technologies and how (or whether) low-carbon policies will be implemented, heavily influenced by geopolitical factors. This uncertainty also extends to impacts on nature and the extent of subsequent market responses, which could amplify the risk of a disorderly transition and potentially trigger a global financial crisis.

The dual facets of this fundamental uncertainty, compounded by the insufficient pricing of climate risks, warrant that investors differentiate certain climate risks as extreme and material, and adopt a different approach to understanding their implications to enable better preparation.

Are financial institutions sufficiently prepared for these extreme climate risks?

Most financial institutions seeking to understand climate risks are currently undertaking stress-testing using climate scenarios that, in many cases, do not incorporate the most extreme outcomes. By omitting scenarios that explore these extreme climate risks, institutions may develop a false sense of security regarding their portfolio’s resilience against certain plausible futures. This oversight can reduce the effectiveness of climate scenario analysis in informing investment decisions and may lead institutions to overlook the importance of developing mitigating action plans if these risks materialize.

How can this limitation be addressed?

One solution for enabling financial institutions to understand and incorporate these extreme climate risks is to expand the range of climate scenarios included in their risk assessments. This involves incorporating additional climate stress scenarios that focus on exploring the most extreme outcomes of specific climate risks. By assessing the financial implications of a 'worst-case' scenario, this approach can highlight the most vulnerable asset classes, sectors, and geographic locations, by revealing where the impacts are likely to be the most severe. These insights can, in turn, be factored into investment strategies and provide a framework for focusing risk management action plans. Depending on a financial institution’s investment beliefs, these insights can also be used to influence strategic asset allocation decisions.

How else can climate stress scenarios benefit financial institutions?

To maximize the value of climate stress scenarios, it is crucial for a financial institution to understand the underlying views and assumptions that shape these outcomes. Not only do these qualitative insights illustrate the drivers behind the outcomes, but awareness of these drivers also enables institutions to use them as 'warning signals' that indicate when a scenario is emerging into reality.

For example, knowing the warning signs that key climate tipping points are being approached provides financial institutions with a tangible way to observe whether these tipping points are materializing and to execute mitigating action plans accordingly.

Conclusion: Financial institutions should embrace a comprehensive understanding of all climate risks

Understanding the full range of climate risks is critical for financial institutions aiming to address the significant potential financial and economic impacts of climate change. Most current approaches to stress-testing often overlook the most extreme outcomes, potentially leading to an underestimation of climate risks. By expanding the range of climate scenarios to include extreme risks, financial institutions can better identify vulnerabilities at a more granular level and implement effective mitigating action plans.

This proactive approach will enhance the resilience of investment portfolios and contribute to more informed decision-making.