Economic losses caused by climate factors over the past 50 years total US$3.6 trillion, according to the World Meteorological Organisation¹. Some US$1.4 trillion of that occurred within the last decade.

If we don’t do anything, climate change poses an existential danger. Luckily, the world is slowly coming round to limiting the carbon emissions that cause average temperature rises, as well as moving to protect some of the natural environments on which biodiversity depends.

Over the shorter term (and on a more prosaic level) climate change may pose a threat to the stability of the financial system. Financial regulators may be preoccupied with bank liquidity concerns right now, but they’ve also been allocating ever more resources to studying these climate issues.

For example, earlier this year, the Federal Reserve Board outlined how it would conduct its pilot climate scenario analysis on the six largest US banks, despite a political backlash against the role of sustainability in investing.

According to a joint report issued by the Financial Stability Board (FSB) and Network for Greening the Financial System (NGFS) in November 2022, there were 67 climate scenario analysis projects completed, in progress or at the planning stage. This compared to 29 in the report a year earlier.

Why does climate change affect banks?

The global banking system is exposed to climate-related risk in three ways:

• Transition risk. This arises from changes in climate policy, the emergence of new technologies and increasing affordability of low-carbon technologies, and changes in investor and consumer preferences. Risks for banks are typically found in the loans made to more carbon-intensive sectors.
  
  
• Physical risk. This stems from changes in weather and climate, including risks such as floods, droughts and storms. It’s typically geographic in nature.
  
  
• Reputational risk. This can emerge if banks are viewed as undertaking activities which may exacerbate climate change (e.g., new lending to fossil-fuel projects) or if they don’t have robust plans to manage existing risks. Lenders with many retail clients are especially vulnerable.

What did climate stress tests find?

Climate stress tests for banks are in their infancy and come with a series of challenges that can make them harder to conduct than traditional tests of financial stability.

But initial results offer some good news. Studies conducted by the European Central Bank (ECB) and Bank of England (BoE) indicate that future potential losses from climate change appear to be manageable and, for now, don’t have implications for banking capital requirements.

The BoE test showed that additional cumulative losses over a 30-year timeframe from climate risk would add around £110 billion (US$133 billion) to potential losses if climate risks were not present.

This conclusion compares with cumulative losses of some £90 billion over the five-year period used in the BoE’s Solvency Stress Test carried out in 2021, which only focused on a severe negative economic and market adjustment.

Too early to celebrate

While investors should gain some comfort from the fact that projected losses can be absorbed, it was also recognised that these losses are likely to be underestimated for four reasons:

• Sample sizes were often small;
• Most assessments had a relatively narrow focus on specific areas of bank balance sheets;
• No assessments were made on the indirect impact of climate risks on economies and markets;
• Poor quality and availability of climate data

Another concern has been the sector’s lacklustre incorporation of climate risks, or indeed its lack of rigour in integrating climate policies, into existing business plans.

The ECB found that some 65% of banks scored poorly and had significant limitations in their stress test capabilities, while only 20% consider climate risk as a variable when granting loans.

Perhaps the sector’s apparent intransigence may be related to findings that more than half of banks’ income from non-financial corporate customers comes from greenhouse gas-intensive industries, or that lenders find it difficult to reconcile multi-decade climate scenarios with the much shorter duration of their loan books.

Final thoughts

Climate stress testing is at a similar stage today as the first macro-focused stress tests were after the 2007/8 global financial crisis, but it’s here to stay.

To increase the robustness of these tests, regulators should aim for more global consistency in setting climate scenarios, increase the number of banks included in a sample size, broaden the scope of bank activities covered, use more dynamic modelling of balance sheets, as well as investigate material data discrepancies.

At that point, stress tests can then be used, for example, to set additional capital requirements at the individual bank level or in a sector-wide context.

Banks are key participants on the climate-change stage, and they will play a major role in a successful climate transition. The data gathered from these tests can be used to reduce downside risks by avoiding losses related to climate change, as well as used positively, by supporting customers as they undertake their own energy transition, or lending to companies that provide climate solutions.

By continuing to engage with regulators, central banks, investors and customers, the industry can help lower climate-change risks and contain future financial instability.