Climate change has become an important strategic issue for global financial institutions as concern grows about lending to, investing in, or insuring companies that are failing to take steps to transition to a low-carbon economy. Stress testing aims to address several key areas for banks and insurers, including asset-level counterparty modelling and the financial impact on loan and investment portfolios. According to the Bank of England’s (BOE’s) framework, there are practical steps banks and insurers need to take to explore the two key risks arising from climate change:
- Transition risk: The risks associated with the significant structural changes to the economy needed to achieve net zero emissions.
- Physical risk: The risks associated with higher global temperatures.
10 Key Takeaways
- There are three broad and interconnected themes that are creating the demand for this type of data and intelligence.
- Climate models, and scenario analysis, can help companies and financial institutions start to understand their exposure to climate risks.
- Stress testing requirements for climate change can be quite demanding for banks and insurers, due to multiple new challenges that add complexity to classical scenario analysis.
- An additional challenge relates to the lack of an established modelling approach that links climate change scenarios to credit risk.
- To assess climate transition and physical risk across both investments and lending, firms need to begin by establishing a baseline.
- There are some opportunities for innovation on climate data and analytics.
- We need to see more standardization around the inputs into analytical models.
- We need more disclosure by companies to have better representation and less reliance on proxies.
- Climate change, ultimately, is a global systemic risk.
- It is important to establish teams that are multidisciplinary with a good knowledge of both credit risk and climate implications that can speak to both sides of the story.
Beyond ESG with Climate Stress Testing: Getting Practical at Banks & Insurers