Climate scenario analysis to assess financial risks: some encouraging first steps

Par Boirard Antoine, Payerols Clément, Overton George, Soares De Albergaria Solène, Vernet Lucas

A growing number of institutions around the world – spurred on by the Central Banks and Supervisors Network for Greening the Financial System (NGFS) and its reference scenarios – are currently carrying out or planning their first climate scenario analysis exercises to assess financial risks. The Banque de France and the Autorité de contrôle prudentiel et de résolution (ACPR – Prudential Supervision and Resolution Authority) are pioneers in the field (Allen et al., 2021). The ACPR recently carried out an unprecedented pilot exercise (and published the results in May 2021) which helped to: (i) raise awareness among financial institutions; (ii) better understand the institutions’ reaction function in terms of portfolio reallocation when confronted with the these risks; and (iii) estimate an initial order of magnitude of their risks and vulnerabilities (which were moderate but far from negligible). This exercise thus paves the way to further new initiatives to improve climate scenario analysis methodologies.

1 A common framework for the first climate scenario analysis exercises to assess financial risks

The financial system is exposed to major and unprecedented risks associated with climate change and the transition to a low-carbon economy. In order to help its members carry out their analyses, the Central Banks and Supervisors Network for Greening the Financial System (NGFS) is examining and developing new tools that are more closely adapted to these risks’ characteristics: non-linear dynamics; the existence of tipping points; irreversibilities; and materialisation over short, medium and long-term horizons. The climate trajectory is also subject to significant uncertainty and past occurrences only partially shed light on future climate events.

The NGFS therefore recommends a climate scenario analysis methodology that facilitates the testing of the financial system for its resistance to climate-related risks – climate stress testing. These scenarios represent various plausible futures. They are based on detailed modelling of energy, economy and climate systems, and provide a methodological framework that is better suited to incorporating climate risks. In its guide to climate scenario analysis (NGFS, 2020), the NGFS makes the following recommendations:

identify the objectives of a scenario analysis, stress test financial institutions, identify structural changes to the economy, and assess risks to own portfolios;
choose the climate scenarios, and assess economic and financial impacts on the basis of these scenarios;
publish the results, even at an aggregate level, notably to help increase awareness among financial institutions.

Test results can also be used as a basis for implementing prudential measures, although currently the authorities’ focus is on improving methodologies.

All the NGFS’ climate, energy and economic data and variables modelled for the 132 countries covered are made freely available. This database can be consulted via two portals, which cover transition risk and physical risk, respectively. It thus particularly aims to step up financial institution mobilisation by facilitating data collection and processing and modelling initiatives.

2 A growing number of central bank and supervisors are engaged in climate exercises based on these scenarios

In October 2021, the NGFS published a progress report on the different climate exercises carried out by NGFS-member central banks and supervisors (NGFS, 2021c). The report shows that the financial community is exceptionally motivated. In total, 31 NGFS members (see Appendix) are using climate scenarios to identify, assess and understand the climate risks that their economies and financial systems face. …