1. Overview of Fed’s Approach for Climate Risk Stress Testing
The Federal Reserve (EBA) published a in September detailing out stress testing procedure to test resilience of financial institutions to climate-related risks. Fed has introduced a measure called CRISK (systemic climate risk) to measure expected capital shortfall of financial institution in a climate stress scenario. Fed has used this procedure to study the climate risks of large global banks in US, UK , Canada, Japan, and France in the collapse of fossil fuel prices during 2020 and noted that there is substantial increase in climate systemic risks during 2020 when energy prices collapsed.
Though this research is based on multiple climate research work undertaken by US Fed last year and currently only considers transition climate risks, proposed approach can also be extended to incorporate physical climate risks.
Objective of this paper is to look at the Fed proposed stress testing approach in-detail against climate risk objectives of central banks, including practical challenges in proposed methodology, how other central banks can adopt the proposed approach, and what can individual financial institutions learn from such systemic climate stress testing approach.
2. Climate Risk Stress Testing Methodology
As guided by NGFS in their report to central banks “climate-related risks are a source of financial risk. It is therefore within the mandates of central banks and supervisors to ensure the financial system is resilient to these risks.”
Climate change is one of many sources of structural change affecting financial system and for central banks to integrate climate-related risks into financial stability monitoring and micro supervision it is essential to assess climate related financial risks in the financial system. Through proposed stress testing approach, Fed addresses an important perspective of how much systemic risks climate change impose on financial system. It contains three major steps.
- Measurement of climate risk factor
- Estimation of climate beta of financial institution
- Compute CRISK i.e., expected equity loss conditional on climate stress
Below is the graphical representation of stress testing procedure proposed by Federal Reserve.
Step 1 – There are several ways to measure transition climate risk factors from policy & legal, technology, reputation & market demand perspective. Fed considered ‘portfolio return of stranded assets’ as a key risk factor in assessing transition climate risk of various assets held by institution’s books.
Step 2 – Climate beta is calculated to measure the sensitivity of bank to market risk and transition related climate risks. bank with high exposure to fossil fuel industries and related infrastructure will have positive climate beta compared to others, and where a bank holds a large amount of loans in the renewable energy sector, the bank’s climate beta could be negative
Step 3 – CRISK is the expected shortfall of a financial institution in a climate stress scenario. It means positive CRISK indicates institution has capital deficit and negative CRISK indicates institution has capital surplus.
- Practical Challenges & Key Considerations
While it appears to be a simplistic exercise to conduct proposed CRISK based stress testing procedure there are number of practical challenges to be addressed by central banks in various touch points throughout the value chain. Challenges include data sourcing & quality, risk factor measurement and calibration, dynamic climate beta calculation, aggregation of CRISK measures & extracting relevant insights. In the below section we discuss about what are those relevant key considerations.
- What does it mean to other Central Banks & Our Recommendations.
Fed’s stress testing exercise considered exposures of various US banks to oil and gas industry and observed climate related impact on the financial system. Proposed approach can very well be followed by central banks from other jurisdictions, for number of other sectors to analyze impact of sector specific climate shocks on overall economy.
Although climate risk factors causing asset stranding are many, it could vary for each sector and few channels will be more relevant for a sector than others. We suggest institutions to capture underlying sector specific assumptions and rationale for any specific sensitivity assumptions. Below are the sample channels through which asset stranding could occur.
- Environmental challenges (e.g., climate change, natural capital degradation)
- Changing resource landscapes (e.g., shale gas abundance, phosphate scarcity)
- New government regulations (e.g., carbon pricing, air pollution regulation)
- Falling clean technology costs (e.g., solar photovoltaic, onshore wind, electric vehicles)
- Evolving social norms (e.g., fossil fuel divestment campaign) and consumer behavior (e.g., certification schemes)
- Litigation (e.g., carbon liability) and changing statutory interpretations (e.g., fiduciary duty, disclosure requirements).
Source : Stranded Assets – A climate risk challenge ( Inter-American Development Bank )
We recommend other central banks follow three-pronged streamlined approach in carrying out system wide stress testing process effectively while carefully ensuring that above considerations are assessed throughout various touch points of stress testing approach. Largely these framework components overlap with traditional economic stress testing and could be leveraged for climate stress testing as well.
- Conclusion & Next Steps Way Forward
It is indeed a meticulous exercise to undertake financial system wide climate risk stress testing with comparable set of data-driven scenarios encompassing a range of different plausible future states of the world, US Fed has taken simplistic but scalable approach that can be widely leveraged by other supervisors across jurisdictions.
While we recognize that various measures taken by global central banks & supervisors to assess climate related risks to financial system are at nascent stage, it is essential that supervisors in other jurisdictions perform similar exercise and share best practices and industry learnings. Not only from sharing relevant climate risk data sets, but central banks could also collaborate through uniformed methodologies and consistent aggregation of stress testing outputs to enable appropriate comparison of outputs.
Sudalaimuthu Gurusamy is a Domain Consultant with the Risk Management practice of the Banking and Financial Services (BFS) business unit at Tata Consultancy Services (TCS). During his 13 years of experience in consulting, he has worked on several global risk and compliance engagements as Risk Domain Consultant/Senior Business Analyst.
A GARP certified Financial Risk Manager™ and Sustainability & Climate Risk™ professional, Sudalaimuthu holds a master’s degree in Business Administration from the Anna University, Chennai, India. His risk consulting experience revolves around Credit risk Transformation, Risk Data Transformation Initiatives, BCBS 239, BASEL II, BASEL III, Liquidity risk management, Loan loss forecasting and provisioning, and risk regulatory reporting. Recently he is working on developing risk solutions to cater to emerging risks domains including operational resiliency & climate ris