Enhanced Scenarios for Climate Stress-tests

June 11, 2024Published by Inspire

Climate scenarios used in central bank stress tests contain a major gap, according to this research paper from the Inspire network: they fail to account for feedback effects from the financial system, investors’ expectations, and policy credibility in realising the scenarios. To address this, the authors – Stefano Battiston and Irene Monasterolo – propose a new generation of enhanced climate scenarios which capture the “endogeneity of climate risk”.

They state that when these enhanced scenarios are used in stress tests, they can yield more robust climate financial risk analysis and guide prudential policy responses. In particular, the authors suggest results can inform adjustments to capital requirements, systemic risk buffers, lending policies and investment mandates to strengthen financial system resilience and align financial flows with sustainability goals.

Climate stress tests aim to quantify potential losses for financial institutions due to climate risks like physical impacts or the transition to a low-carbon economy, conditional on different climate mitigation pathways.

The authors highlight the increasing use of forward-looking, balance sheet-based climate stress tests by supervisors, such as the European Central Bank’s economy-wide climate stress test in 2022. However, they emphasise that current scenarios neglect the impact of investors’ expectations and the subsequent consequences this has on climate outcomes.

This poses dangers for financial stability as it could lead to a gap between assumed and actual investments in low-carbon activities, resulting in a potential system-wide underestimation of risks and exacerbating the risk of disorderly transitions or even missed climate targets.

The endogenous scenarios presented in this paper instead model how investors’ expectations about the credibility of climate policies affect their investment decisions across high versus low-carbon activities. This information is fed back into the realisation of the climate scenario itself.

“In a nutshell, the idea is that if investors find a climate policy such as the introduction of a carbon tax credible, they will more likely reallocate capital into low-carbon investments early and gradually. In contrast, if they do not find the policy credible, they could have a delayed or sudden reaction” which “can lead to sudden adjustments in values of high- and low-carbon assets and to market instability”.

The enhanced scenarios connect large scale process-based integrated assessment models (IAMs) with a climate financial risk (CFR) model. The IAM provides sector output paths, while the CFR models how policy credibility impacts investors’ risk pricing and capital costs across technologies. This adjusted cost of capital then feeds back into the IAM, yielding self-consistent climate scenarios that emerge from the interactions between finance and the real economy.

These endogenous scenarios can be integrated into the climate stress testing framework used by central banks and financial supervisors, and used to enhance the current NGFS scenarios with new self-consistent scenarios from the IAM-CFR model, say the authors.

This page was last updated June 11, 2024

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