Leading economist Gita Gopinath, a Harvard professor, told a briefing at the World Economic Forum in Davos that many banks are adding the chance of hell and high water to their stress tests.
“The stress tests used to be merely about earnings and outlook, now banks are adding natural disasters,” Gopinath
This is one of the greatest long-term threats to the world in 2019, according to the World Economic Forum’s Global Risks Report that paints a bleak picture of the year ahead full of trade wars, cyber-attacks and unemployment.
Four of the five top risks by impact are posed by the elements: failure to mitigate the effects of climate change; floods and storms; water crisis, plus earthquakes, tsunamis, volcanos and electric storms.
Economists Gopinath and Laurence Boone, a PHD from London Business School, painted a gloomy picture of globalisation. They identified trade tensions, Brexit, worsening financial conditions and the slowdown of China, plus the wiping out of jobs through increased competition as major downsides.
The economists recommended more training to overcome the job losses; the downside to this? More taxes to pay for it, they said. A recommendation unlikely to give much cheer to the world’s hard pressed companies.
The threat that climate change and climate-related risks pose to the stability of both financial institutions themselves and the global financial system as a whole has steadily been gaining prominence. Regulators as well as market participants are beginning to tackle in earnest the challenges presented by climate-related risk management.
On 30 June 2020, the Hong Kong Monetary Authority ("HKMA") issued the White Paper on Green and Sustainable Banking ("White Paper") to share initial thoughts on their supervisory approach to addressing climate issues. In the White Paper, the HKMA lays out their expectation that climate-related risks considerations should be incorporated into a financial institution’s (“FI”) existing risk management framework. The HKMA notes that stress-testing, as one of the key methodologies and tools to measure climate-related risks, should be actively explored.
The use of stress testing to measure climate-related risks is a relatively new development. On 7 July 2020, the HKMA issued a circular entitled Range of Practices for Management of Climate Risks ("Climate Risk Circular") announcing that it will invite some FIs to participate in a pilot climate change stress testing exercise in 2021.- and onwards
Taken together, both the White Paper and the Climate Risk Circular show that the HKMA is starting to prioritise the integration of climate-related risks into stress testing. FIs will need to start building the capacity to conduct climate change stress testing to meet the HKMA’s expectations in this area.
Developing Capacity in Climate Change Stress Testing
There are three main types of climate-related risks that should be considered in a climate change stress scenario – physical risk, transition risk, and liability risk.
Physical risk is the risk associated with the physical effects of climate change, for example flood damage caused by extreme weather events.
Transition risk is the risk associated with policy and regulation changes in response to climate change, for example new carbon taxes that are implemented in order to reduce emissions under the Paris Agreement.
Liability risk is the risk associated with legal suits demanding compensation for inadequate disclosure of climate-related risks or inadequate pre-emptive action, for example pollution.
For climate change stress testing, most of the FIs should focus on the impact of both physical and transition risks in their stress scenarios.
The objective of climate change stress testing is to assess how climate-related risks impact a FI’s business across all sectors and geographical locations under stress scenarios. Based on the results of the stress testing, FIs will be able to establish remediation measures that will help them better respond to the threat posed by climate-related risks. FIs will be able to estimate the financial resources, including both capital and liquidity, that need to be retained to absorb losses under stress scenarios. Furthermore, FIs can utilise the results of stress testing to enhance their business strategies in asset liability management to reduce the climate-related risks in their portfolio, and updating their Risk Appetite Statements.
FIs should look to leverage existing stress testing methodologies and capabilities to develop their approach to integrating climate-related risks. However, climate-related risks differ from traditional risk types, and FIs will need to consider the following:
- Data inputs of stress testing
When designing stress testing for traditional risk types, FIs often rely on historical data as inputs to reflect the risks to which they are most exposed. However, as climate-related risks depend on multiple uncertain events, e.g. political, technological, and economic viability, they are more prone to a fat-tailed distribution as compared to traditional risk types. This means that the impact of climate-related risks under extreme cases will be larger than that expected under typical statistical assumptions. Therefore, FIs should incorporate hypothetical data inputs into climate change stress testing to take extreme events into consideration.
- Portfolio segmentation in different sectors
Climate change and the transition to a carbon neutral economy may have different effects on the business portfolio in different sectors. FIs should re-assess the portfolio segmentation to group exposures in sectors which are vulnerable to the same climate-related risk factors. For example, rising temperatures may impact loans in the energy and power sectors, but may not impact the education sector to the same degree. Also, more attention should be paid to the sectors in which climate-related risks will face sudden materialization of physical and transition risks.
- Time horizons
Climate-related risks play out on longer time horizons than traditional risk types under stress testing. Given that climate-related risks also carry with them a higher degree of complexity and uncertainty, the capability to carry out stress testing with a longer time horizon, for example 30 years, is important.
Challenges
Given the breadth of the impact from climate-related risks across all sectors and geographical locations, FIs may encounter difficulties during the development and implementation of climate change stress testing. FIs should pay special attention to the following:
- Stress testing methodology
Climate change stress testing should be granular, reliable, and complex enough to integrate different kinds of parameters and their impact, which requires significant modelling skills. A key step in the development of climate change stress testing is identifying the relationship between the climate risk factors, both transition and physical (e.g. carbon tax policy, temperature change) and financial information (e.g. provision). By doing this, FIs can estimate the impact of climate-related risks on their portfolio in different sectors under stressed scenarios. - Data availability and granularity
Data availability and granularity are fundamental for robust stress testing. Different sectors in a portfolio may be subject to different types of risk factors in climate change stress testing, e.g. temperature change for the energy sector, and sea level change for the real estate sector. Climate change stress testing involves collecting extensive and granular historical and forecast climate data, which will require significant data resources. - Awareness of climate-related risk management
As climate-related risks are a relatively new type of risk in regulatory reporting and banking system, the awareness within an FI may not be strong. FIs may not have sufficient expertise with climate-related risks or the experience to develop and implement climate change stress testing and climate-related risk management. 
