Enhanced scenarios for climate stress-tests
This paper explores how a newly developed methodological framework for enhanced climate stress-tests can be used by central banks and financial supervisors to inform the design of prudential measures. Climate stress-tests are a powerful tool to quantify the exposure of financial institutions to climate financial risks. Scenarios play an important role in stress-tests, but those often used today do not account for endogenous factors, such as the response of the financial system. This could in turn lead to the underestimation of climate risks and missed opportunities for climate change mitigation.
Main messages from the publication include:
- Several central banks and financial supervisors across the world are in the process of assessing climate risks for the banks and financial institutions under their supervision through exercises referred to as climate stress-tests (or climate scenario analysis in some cases).
- Climate stress-tests build on the traditional stress-test by integrating climate financial risk, in the form of both physical and transition risks, to help financial institutions to assess and manage climate-related financial risks. These are often based on scenarios developed by the Network for Greening the Financial System (NGFS).
- However, these climate scenarios are constructed without accounting for the role of the financial system and, in particular, the interplay between investors’ expectations, policy credibility and risk materialisation.
- To overcome this limitation, the NGFS scenarios can be enhanced using a methodology that captures the key role of investors’ expectations, policy credibility and risk assessment within the realisation of the scenarios.