Climate risk stress testing: A critical survey and classification

door: Henk Jan Reinders, Dirk Schoenmaker en Mathijs van Dijk

1. Introduction 

Climate change and the associated policy measures to mitigate Greenhouse Gas (GHG) emissions pose a novel challenge for central banks and financial supervisors and their traditional ways of gauging potential losses from severe adverse events. While financial risk methodologies are typically assuming that the future will be similar to the past, climate change is likely to lead to fundamental and often detrimental changes over time in a broad set of regions and economic sectors (Intergovernmental Panel on Climate Change, 2022). The economic costs related to climatic change are potentially very high, for example due to the increasing frequency and severity of natural disasters and sea-level rise in many regions of the world (e.g., Tol, 2002). Moreover, reducing GHG emissions to limit climate change is expected to come at an economic cost in many economic sectors, at least in the short run (Acemoglu et al., 2012, Nordhaus, 1992). This means that, one way or another, it is likely that a broad range of economic and financial assets will face changes in their value – with potentially important implications for prudential supervision and policy making.

In particular, from the perspective of regulators concerned with the health of the financial system, a key question is what the potential impacts of climate change and its mitigation are on the profitability, solvency, and liquidity of banks (Campiglio et al., 2018). Efforts in recent years by central banks and financial supervisors have focused on understanding and gauging climate-related financial risks, including “transition risks”, which capture structural changes in the economy due to GHG emission reduction, and “physical risks”, which capture the effects of a changing climate (Batten et al., 2016, Nieto, 2019). Of specific interest are transition and physical risk scenarios that could cause large economic and financial losses, impeding financial stability.

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