Climate Stress Tests Help Gauge Financial Sector Risk Exposure

The financial sector will be at the forefront of the shift to a low or zero carbon economy, which could pose financial and operational risks to the industry. However, climate change stress tests can be a valuable way to gauge environmental and climate-related risk exposure, and indicate whether the institutional framework can address system-wide risks, according to S&P Global Ratings.

The ratings agency said it has been increasingly incorporating environmental considerations and data into its credit rating analyses.

“As testing becomes more sophisticated over time, it should suggest whether banks’ management teams need to adjust risk appetites, develop tools to better monitor and manage climate-related risks, and even consider changes to their business models,” S&P Global Ratings Credit Analyst Francesca Sacchi wrote in a recent comment.

Financial regulators use so-called “stress tests” to measure how prepared major banks are if they have to face extreme and unexpected, yet possible, economic shocks. They were widely implemented after the 2008 global financial crisis to help prevent system-wide catastrophes in the future. They can also help ensure the financial system is resilient to the transition to a low-carbon economy by providing more and better information to market participants on climate change risks.

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In recent months, European financial regulators have been conducting climate stress tests to assess the financial sector’s vulnerability to climate change, foster higher disclosure, and encourage banks to embed environmental risks in their strategy and risk management. According to the European Central Bank (ECB), preliminary results show that in the absence of additional climate policies, the costs to companies as a result of extreme weather events rise substantially and greatly increase their probability of default.

The ECB also said the short-term costs of the transition to net-zero carbon emissions “pale in comparison” to the costs of unchecked climate change in the medium to long term, adding that the early adoption of zero-carbon policies brings benefits in terms of investing in and rolling out more efficient technologies.

However, Sacchi said too much should not be read into the conclusions of the stress tests, not only because of uncertainty about the pace and impact of climate change, but because the tests did not consider spillover effects, such as supply chain disruptions or amplifications that are typically observed during financial stress or crises. Nevertheless, she did point out some notable takeaways from the tests, such as:

Further delays in addressing climate change will only increase the likelihood of environmental events and could severely affect the broader economy and ultimately destabilize the financial system;
A high correlation exists between banks’ vulnerability and the concentration of their assets in geographies and economic sectors more sensitive to physical risks;
The impact of the climate scenarios on banks’ balance sheets varies significantly and depends on the severity of the scenario; and
Banks more exposed to physical risk tend to be less strongly capitalized and less profitable.

“They provide a forward-looking view on how different climate scenarios could affect banks’ assets,” Sacchi wrote. “Supervisors are not yet penalizing banks with higher capital requirements for such long-range risks, but they are ratcheting up the pressure on bank management to proactively tackle these risks.”