The challenges of climate risk stress testing for banks

Since the launch of the Climate Risk Stress Test, banks in Europe are obliged to conduct a stress test based on a set of different climate scenarios. Early feedback from the market shows that designing and conducting the tests has been a major challenge. To learn more, we sat down with Sebastiaan Bredenbeek from RiskSphere.

The Climate Risk Stress Test (CRST) was launched in 2022 within the mandate of the European Central Bank, which sought to find out how much climate risk affects Europe’s banks. The process and the results showed that testing this type of risk is pioneering – but also complex.

“Capturing the multifaceted dimensions of climate change within a singular stress testing scenario presents a considerable challenge,” said Bredenbeek, a senior consultant at financial services consultancy RiskSphere.

“For every scenario, it’s essential to project future greenhouse gas emissions, ascertain the rate at which the planet will warm in response to these emissions, evaluate the societal repercussions, interpret economic consequences, and ultimately determine the financial impact on individual firms.”

To make matters even more complex, there is a notable lack of historical data that can be used to inform models. That is due to the incredible urgency of the climate crisis and the scale of action required to prevent further crisis, which makes standards and approaches very dynamic.

Climate risk stress tests have different characteristics when compared with traditional stress tests. Among those contrasts are major timescale differences, with climate stress tests featuring gradual shifts over time, rather than sudden shocks.

There is also a difference in recovery, with climate stress tests often seeing a new baseline low after major stresses, where financial stress tests are more likely to see a “V-shaped”, more gradual recovery.

“Traditional stress tests typically stem from financial shock events. In contrast, climate risks are more inclined to emerge through the real economy,” notes Bredenbeek. “Given the nuanced relationship between banks and the real economy, predicting shocks and significant loss events becomes inherently more complex.”

For both traditional and climate risk stress tests, simulated potential recoveries are hypothetical and thus tend to be simplified. For climate stress tests, that can easily step into the territory of oversimplification, considering climate risks involve a large amount of complex and interconnected issues.

“Often overlooked dynamics, such as the interplay between physical and transition risks, tipping points, and potential disruptive socioeconomic factors like mass migration, are central to understanding the profound threat climate change poses to the financial system and future generations.”

There are so many complexities and uncertainties involved in the risk assessment process, that any final outcomes to such climate-related stress tests should be considered with caution. Despite that, Bredenbeek argues that the value of such stress testing still stands.

“While it’s important to recognize that the current maturity and confidence of climate risk models – and by extension, the outcomes of climate risk stress tests – may not meet the standards traditionally expected for decision-making, these results can act as a springboard for discussions on climate risk within organizations,” according to Bredenbeek.

It is important to note that the CRST is considered a learning exercise, rather than a pass-or-fail test with any implications for the financial institutions involved. Despite that, however, the somewhat disconcerting findings showed that carbon-intensive sectors were still a significant source of interest income for many EU banks.

The percentage of interest income generated by European banks that was derived from a long list of carbon-intensive industries was markedly higher (at 65%) than the share of those industries in the bloc’s overall economic activity (54%). Perhaps worse, 21% of reported income from banks came from what the ECB considers highly greenhouse gas-intensive industries.