With the effects of climate change being more visible than ever in our daily lives and the way business is conducted, financial institutions are more inclined to incorporate climate-related targets into their strategy and risk management frameworks.
However, the effective measurement of climate risk exposures in portfolios remains challenging. Past experience in the industry related to scenario analysis and stress testing provides the financial industry with the opportunity to get a quantitative view of their exposure to the transition towards a carbon-neutral economy. Moreover, an increasing number of regulators, such as the ECB and the Bank of England are forcing banks to conduct internal climate risk stress tests on their portfolios while taking into account the most prominent transition scenarios.
As climate stress testing entails a significantly longer timeframe and different impact methodology compared to past regulatory stress tests, many financial institutions will have to redesign their existing stress testing frameworks.
Analysis of the requirements to ensure the development of a compliant climate stress testing framework.
Ensuring a coordinated and aligned approach between the involved business lines in the stress test.
Translation of the different transition scenarios into meaningful and actionable information and risk drivers.
Assess your exposure to climate risk under different scenarios.
Use an approach that relies on the existing internal frameworks to reduce potential hurdles.
Reporting & Metrics
Analysis of the stress testing results and disclosure of relevant metrics as input for strategy or risk management decisions.
On the 18th of October 2021, the ECB published the methodological outline for the mandatory 2022 climate stress test. The exercise is divided into 3 clear modules.
Finalyse proposes an all-encompassing approach to ensure compliance with the methodological requirements from the ECB stress test. The process includes the organisation of workshops across different business lines in the institution to create awareness and an internal knowledge base. Simultaneously, the outcome of the workshops forms the basis of the internal framework and division of roles that need to be disclosed in Module 1.
Module 2, climate risk metrics, indicates a significant data collection exercise where Finalyse can support by implementing sound governance process and control mechanisms to ensure the completeness and correctness of the used information for the completion of the Module 2 as well as the input for the modelling exercise in Module 3.
Module 3 comprises the actual stress test, where the financial institution will need to report the impact of transition scenarios in terms of both market and credit risk over the short and long term. Finalyse proposes a pragmatic approach where the existing models and frameworks are leveraged to keep the implementation as frictionless as possible while ensuring a strong base on which more complex methodologies can be built in the future.
The ECB has published the “Guide on climate-related and environmental risks” in November 2020 to encourage banks to facilitate investments in a more sustainable economy. This guide outlines the ECB’s take on the prudent management of climate risk and describes how the institutions are expected to integrate that dimension into their already existing risk management framework in the form of 13 recommendations. This article outlines our interpretation of the ECB guide and presents some key points to facilitate understanding and implementing those regulatory expectations from the point of view of banking institutions.Read
The article walks the reader through the different modules of the 2022 ECB Climate Stress Test. While we still find ourselves at the dawn of introducing climate risk into the existing risk management frameworks, the ECB continues to pave the way for financial institutions. In the methodology paper released in October 2021, the regulator has showcased their expectations for the upcoming bottom-up stress test. By elegantly side-stepping the intricacies of advanced climate modelling, financial institutions are enabled to start their climate stress testing journey while laying strong foundations for more advanced approaches in future exercises.Read