Climate scenario testing - what financial companies need to know

Climate-related scenario analysis is required by an increasing number of financial reporting and risk frameworks, such as the Taskforce for Climate-related Financial Disclosures (TCFD). Exploring long-term climate scenarios across a range of physical and transition risks may seem daunting to banks, re/insurers and pension funds and beyond their immediate in-house capabilities. However, publicly available research on climate change (from the Intergovernmental Panel on Climate Change, IPCC) and its expected effect on the economy (from the Network for Greening the Financial System, NGFS) can be used. Combined with the climate stress tests already implemented by various central banks and financial supervisors it can help to derive potential financial impacts on a given financial institution (Figure 1).

A strong regulatory push

The TCFD recommendations have inspired regulatory guidelines worldwide including in Switzerland, where climate reporting will be mandatory for large companies from 2024. One such recommendation is that financial institutions treat climate risks as financial risks. To assess climate risks and opportunities for companies, the main focus is on stress testing and scenario analysis to assess the impact of future climate change on financials¹. The International Sustainability Standards Board (ISSB) also voted in November 2022 that companies are required to use climate-related scenario analysis to report on climate resilience and to identify climate-related risks. Regulators and financial supervisors worldwide are expected to extend their requirements to encompass climate-related scenario analysis, but a survey conducted by the European Central Bank (ECB) showed that around 60% of banks do not currently incorporate climate risk stress-testing into their testing frameworks and models².

Publicly available climate scenario frameworks

The NGFS is a network of over 100 central banks and financial supervisors that share best practices and contribute to sustainable development of the financial sector³. They developed a series of scenarios that include the most comprehensive macro-financial data available for assessing environmental and climate financial risk. The NGFS scenarios help mobilise mainstream finance to support the transition to a more sustainable economy. The third set of NGFS scenarios, released in 2022, offer updated data, improved sectoral granularity and deeper integration of physical hazards (including falling renewable pricing and mitigation costs).

The different scenarios are modelled using climate-related macroeconomic and financial models, exploring a wide range of transition and physical risk scenarios across different regions and sectors. These models are driven by temporal and regional changes in policy (most notably in carbon prices, shifts in energy prices in fossil and renewable energy sectors, and increases in commodity prices), rates of technological change (e.g., decarbonising heavy industries) and use of carbon dioxide removal technologies. Climate change is a new source of risk in such scenarios, but it still manifests itself through preexisting risk drivers (physical damage, depreciation of assets, etc.).

While these exploratory scenarios are not forecasts, they provide a common framework to identify future risks and prepare the financial system for potential shocks based on plausible futures for financial risks. The NGFS scenarios specifically explore potential futures including:

1. orderly scenarios where climate policies are immediate and gradually more stringent, thus limiting both physical and transition risks;
2. disorderly scenarios where policies are delayed and abrupt or not coordinated across countries and sectors leading to higher transition risks; and
3. hot house world scenarios where insufficient global efforts do not mitigate global warming resulting in severe physical risks (Figure 2).
   

How will the climate transition look?

The NGFS emphasises that an immediate, coordinated and orderly carbon transition will be less costly than either inaction or sudden disorderly transitions in mid to long term. Continuing current policies or using nationally determined contribution scenarios (hot house world scenarios) will lead to the most physical risks and the strongest negative impacts on GDP beginning at around 2040. Failure to adopt the requisite measures to current policies would lead to an impact from physical risk of around 20% of GDP by 2100. By contrast, an orderly transition might limit the economic losses from transition risk to around 4% of GDP by the end of the century. For all scenarios, the physical risks now outweigh the transition risks, and their repercussions on financial institutions will more directly impact insurance companies due to damage claims payments, in addition to depreciating asset values and default events that affect all financial institutions.

While critics of the NGFS scenarios suggest the actual impact on physical risks are understated because the models do not yet capture potentially massive disruptions in human behaviour and natural systems (social and physical tipping points), climate-risk scenario analysis is still imperative for financial institutions to prepare for the future, and the NGFS scenarios remain a widely accepted industry standard.

Additionally, our own analysis indicates that financial institutions across the globe have different levels of exposure to climate-change risk depending on these key factors:

• Economic (sub-)sector plays a major role in which corresponding assets and liabilities are most exposed to climate-change risk due to differences in emission-intensity.
• Geographic exposure of assets and liabilities is demonstrated in both how the regional climate will change due to the physical location of the country or region, and the differences in investments in climate adaptation in the different geographies.
• Asset classes that are most exposed in terms of bonds, equity, or real estate also varies across financial institution (bank, insurer, pension fund).
  

To achieve an orderly net zero transition, all sectors of the economy will need to contribute to an ambitious transition strategy. Investment flows must significantly be directed towards renewable energy and carbon dioxide removal technologies, requiring ambitious and immediate policy action and technological innovation. Although the required action is ambitious, many of today’s available options in all sectors offer substantial potential to reduce net emissions by 2030 and several technologies are already economically favourable in today’s carbon price markets⁴.

Using supervisory stress tests to implement climate scenario analysis

Several leading central banks and financial supervisors (CBFS) such as the Dutch National Bank, the Bank of England, or the European Central Bank have started to perform their own analysis using the NGFS scenarios, reports and framework with a focus on key policy targets in their jurisdictions⁵. While climate-risk scenario analysis has initially focused on assessing ‘top-down’ macro implications on the regional or country level, individual financial institutions also began their own ‘bottom-up’ assessments of their assets and balance sheet, often in the context of supervisory stress tests. Financial institutions across Europe have initially been leading the way and the US Federal Reserve Board is following suit with their own pilot exercise conducted by the six largest US banks to be published later this year.

The first step for any financial company is to assess their readiness and capacity to apply a climate stress testing framework in terms of data (finding the right data proxies where needed), governance, risk, and strategy, and to determine where external support may be needed. The next step is to quantity their exposure to climate-related physical and transition risks, assessing where such risks may be material and warrant a further quantitative analysis. Finally, banks, re/insurers or pension funds need to perform the actual quantitative assessment of the potential financial impacts under different climate scenarios⁶.

Financial institutions are at very different readiness levels to conduct their own climate scenarios projections, depending on their size, business model and level of sophistication. If they encounter difficulties at any stage during the process outlined above, the detailed climate stress tests from central banks and financial supervisors around the world may be used to inform the company’s projections and to supplement the more high-level body of scenario analysis produced by the IPCC and the NGFS. Supervisory climate stress tests can be used to help financial institutions bridge the gap between the general outputs of macro projections and the specific inputs that their own internal financial models require.

Outlook

Financial institutions must act and assess their resilience to climate risks. Understanding climate risks will enable your company to make data driven decisions on climate policies and investments – also opening new opportunities in the transition to net zero. Banks who neglect climate risks in their lending practices, insurers who continue to overlook climate risks in their underwriting or pension funds who fail the constituents who have entrusted them with their savings, will undoubtedly bear a significant financial burden from climate change. They will also expose themselves to a broader array of climate-related risks such as regulatory intervention, shareholder activism, customer loss, or climate litigation. Deloitte can assist your company through its climate risk assessment journey, using pre-existing climate and economic frameworks with our regulatory and financial modelling expertise⁷ and supporting you to assess the right methodology, frameworks and decisions in your decarbonisation journey.

Footnotes & References

¹This is traditionally known as financial materiality, while ‘double materiality’, assessing both financial and impact materiality’ (a company’s inside-out impact on climate and society), is gradually becoming the most relevant way to holistically assess an organisation’s broader ESG risks and opportunities.
²European Central Bank, Banks must sharpen their focus on climate risk, ECB supervisory stress test shows. July 2022.
³Network for Greening the Financial System, NGFS climate scenarios for central banks and supervisors. September 2022.
⁴Intergovernmental Panel on Climate Change, Climate Change 2022 – Mitigation of Climate Change, Summary for Policymakers. 2022.
⁵Financial Stability Board, Climate Scenario Analysis by Jurisdictions: Initial findings and lessons. November 2022.
⁶The difference in financials between projections with and without climate change is sometimes referred to as the climate value-at-risk.
⁷Deloitte, Climate Stress Tests: Onwards and Upwards. February 2023.