Climate Shock: time for more stressful tests on banks

Extreme weather events are becoming bigger and more frequent

There is no doubt that the central banks, supervisors and regulators recognise the urgency of climate change. This is why they are conducting stress tests on the financial risks that it poses to the banks and other financial institutions. Sadly, the signs are that the scenarios that they have so far provided for this purpose will not be stressful or shocking enough to make much difference the financial institutions’ behaviour. Perhaps inadvertently, they risk fostering complacency.

I was privileged to be invited to address this in an article for Environmental Affairs, Policy Exchange’s quarterly policy journal, published just ahead of the COP26 climate talks in Glasgow. In it I note that despite the central banks’ humility about their current modelling, their scenarios suggest that climate risk will make little difference to growth or financial losses even on a 30 year horizon.

In the ECB’s case, the cumulative total difference in GDP between their business-as-usual ‘hot house’ scenario and an orderly policy ‘Net Zero’ scenario is barely 3%. This is despite escalating physical risks and the dramatic transformation in the economy that decarbonisation will entail. This modest range of variation is against the basic essence of the scenario method, which is to explore a wide enough range of possibilities to provide strategic insights.

If the central banks wish to inject the needed urgency into the financial institutions’ embrace of climate risk the next phases of their stress testing exercises will have to rise to the challenge set by the BIS for an ‘epistemological rupture’. There are four ingredients that could feed into the rethink required; their scenarios should:

1. Focus on shorter time horizons in line with traditional solvency stress tests and the planning horizons of the financial institutions. Most of them are already signed up to being ‘Net Zero’ by 2050, so the challenge is to operationalise this now and to recognise that the financial risks and opportunities are far larger and more immediate than the central bank scenarios suggest. The ECB’s latest announcement that next year’s stress test will incorporate policy and weather shocks in 2022 is therefore a welcome step forward. 

2. Stop ignoring or downplaying crucial risks. Extreme weather events, political disruptions, policy shifts, financial markets, behavioural and technological change are all aspects that are difficult to calibrate and model. But failing to account for them severely reduces the realism and useful of the scenarios for stress testing purposes.

3. Recognise that non-linear dynamics will accelerate change, for good or ill, making the likelihood of extreme outcomes far more likely. The central banks’ models yield smooth orderly changes and fail to capture the risk that the climate may breach thresholds beyond which damages may accelerate and become irreversible or existential. Socio-political disruptions, policy shifts and market spikes and crashes could all feature in more illuminating short term scenarios.

4. Adopt a systemic approach to factor in the complex interactions between the drivers and impacts of climate change. Earth systems and the economic, financial, political and social systems are interdependent in a way that can lead to powerful feedbacks. This adds layers of uncertainty which argues for embracing the ‘precautionary principle’ by making assumptions that result in a broader range of outcomes. 

A prime illustration of the problem is that the central banks’ scenarios start from the same economic growth baseline, even though it is obvious that different growth rates and cycles would dramatically alter the evolution of climate risks. What makes this particularly odd is that macroeconomic shocks are at the heart of traditional stress testing exercises.

But the scenario method provides room to develop plausible narratives to address these complexities. The pandemic has provided a timely lesson in how nature can trigger rapid changes in human behaviour, whether it be politics and policy, markets and innovation, or social norms and consumer behaviour. In the case of climate change, official forecasts continue to underplay the fact that the costs of renewables are falling, partly through policy support, in a way that is triggering tipping points in business and consumer demand.

On the flipside, the central banks also understate how policy inertia or missteps could crystallise longer term financial risks from stranded fossil fuel assets and labour well before 2030, let alone 2050. It is time to inject some real stress into their climate stress tests.

Note: A longer version of the Environmental Affairs article will be published soon.

About markcliffe

Board Advisor and Thought Leader on the impact of disruptive change. Former Chief Economist of ING Group
This entry was posted in Banking, Climate Change, Sustainability and tagged , , , , , , . Bookmark the permalink.

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