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Climate risk analysis is ‘not a standard stress test’: IMF

© Shutterstock / DCStockPhotographyIMF plaque.

Effective climate risk analysis is crucial to prepare companies and economies as the world shifts to net zero and experiences more and more climate disasters. However, analysing climate risk is still not fully standardised and understood, leaving knowledge gaps, which could impact financial stability.

IMF publishes paper outlines best practices for analysing climate risks for banks.

Climate risk analysis requires a much more complex and integrated approach compared to standard stress testing, often based on unknown data and scenarios.

Improving analysis of climate risk will be key to inform policies and regulations to manage climate risks to ensure financial stability.

As part of its efforts to prepare the global financial sector for the transition to a decarbonised economy, the International Monetary Fund (IMF) has released a paper on approaches to climate risk analysis. The paper outlines the IMF’s staff approach to assessing the impact of climate change on financial sector stability under the organisation’s Financial Sector Assessment Programme (FSAP).

The FSAP is the IMF’s “premier instrument” to assess risks to financial systems and policies to mitigate and manage risks. The IMF has already begun to implement a work plan to incorporate climate change considerations in risk analysis, regulation and supervision, and monetary policy operations.

The institution is working with other international organisations such as the World Bank, OECD and the Network for Greening the Financial System (NGFS) to establish international definitions, standards, and best practices when it comes assessing, mitigating, and adapting to climate risks in the financial sector.

The report acknowledges that climate change poses risks to economic and financial stability, yet in parallel “presents opportunities for growth and job creation offered by the transition to a greener economy” if the right proactive policies to manage climate and transition risk are taken by governments and central banks.

The IMF approach to climate risk analysis

The climate risk analysis considered by IMF staff is “not a standard stress test” according to the paper, such as those undertaken by the Bank of England and the European Central Bank.

Standard stress tests assess a bank’s resilience “based on pass-fail criteria regarding whether capital falls below given regulatory minima” founded on well-established historical relationships between macro-financial stress, banks, and system-wide capital and liquidity. Essentially, this means that they can assess the plausibility of a risk scenario based on historical experience.

However, when it comes to climate risk, the same methodology cannot be applied as there is limited historical experience to draw on and uncertainty regarding climate modelling. Thus, climate risk analysis is “not currently focused on quantifying possible capital needs of financial institutions relative to regulatory minimum requirements”.

At its core, climate risk analysis is based on “assumptions” on the potential future paths for global emissions of greenhouse gases (GHG) and their inherent effect on the climate. However, the scale of emissions is dependent on a variety of uncertain factors such as policies, new emerging technologies, speed of emissions reductions and adaptation solutions.

There are two main categories of risk that emerge as a result of climate change – physical risks and transition risks. The IMF analyses theses risks using the Intergovernmental Panel on Climate Change (IPCC)’s scenarios.

Physical risks

These scenarios expect that the largest consequences of physical risks are expected to emerge over the next 30 to 80 years, although they recognise that these may materialise under a shorter time horizon given modeling uncertainties and observations of rising extreme weather events.

In any case, this time horizon is well beyond the typical 3 to 5 years horizon typically considered for risk analysis in FSAPs. At the same time, the impact of extreme weather events around the world and the rapidly changing climate in many parts of the world reminds us that many of these predictions are coming true significantly earlier than anticipated.

Transition risks

The other side of the coin from physical climate risk is transition risk. The larger the policy steps taken to lower emissions, the lower the rise in temperature and thus climate risks. Yet on the other hand, the larger the policy steps taken to lower emissions, the higher probability of transition risks.

‘What-if’ framework helpful to deal with future uncertainty

The IMF paper outlines that there is thus a “trade-off” between the economic and financial impacts from climate change and the policies to mitigate climate change, and therefore physical and transition risks need to be analysed within one framework instead of in isolation.

Since there are a seemingly infinite amount of variables and uncertainties for these risks, the IMF recommends that countries assess which risks are the most relevant for them based on the organisation’s climate risk assessment matric (C-RAM).

Based on these priorities, a country should develop both temperature and emissions scenarios along with climate scenarios to add to the bank solvency stress testing framework to incorporate physical and transition risk.

The IMF recommends using a micro-macro approach for developing climate scenarios if granular data is available, which is built on both the implications of climate risks for banking system resiliency as well as borrower-level (i.e. corporates and households) assessments and their implication for banks.

The paper recognises that these methodologies are still a “work in progress”, but that they can offer a “what-if” framework that is helpful to deal with future uncertainty.

How to implement climate risk analysis in financial policy

The IMF states that climate risk analysis is crucial to raise awareness of the risk, and inform adaptation needs and opportunities for banks and the financial sector. This can has the potential to “drive gradual early adjustment” and “help inform policies needed to enhance risk management and the resilience of the financial system”.

The organisation sees the role of climate risk analysis scenarios primarily to inform supervision and regulation. However, the methodologies used still require further work due to the complexity of climate analysis versus standard stress tests, as well as the continually evolving nature of climate change and poor quality of data disclosure.

Because of these challenges, the IMF explains that no jurisdiction as of yet has envisaged calibrating prudential policies such as capital requirements on the basis of their climate scenario analysis.

However, the European Central Bank (ECB) has recently called for macroprudential policies to better manage climate risks after they published an analysis on how climate risks can destabilise financial systems in Europe. Yet, they recognise that there are no macroprudential instruments that are “readily available and fit for purpose without some adaptation”.

Ultimately, it seems like the international financial sector is still woefully underprepared and ill-informed about the risks that climate change can have on financial stability. This lack of knowledge is currently preventing governments and international organisations from taking the steps needed to mitigate climate risk.

Continuing to improve the analysis of climate risk is therefore crucial to better inform stakeholders, and allow them to take proactive steps to adapt to climate risks in the financial sector.

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