Climate Stress Test

Traditional stress tests look at how financial institutions would cope with shocks such as recessions or market crashes. Climate stress tests apply similar methods to climate risks, but usually over much longer time horizons, often several decades.

Typical scenarios include an orderly transition, where climate policies are introduced early and gradually; a disorderly transition, where action is delayed and then sudden; and a scenario with little action, where physical risks from climate change become severe. Many central banks use scenarios developed by the Network for Greening the Financial System.

For example, a climate stress test might estimate how much a bank’s loan losses would rise if a sharp increase in carbon prices hurt its fossil fuel borrowers, or if more frequent floods damaged properties it had lent against.

Central banks and supervisors, including the European Central Bank and the Bank of England, have run climate stress tests or scenario exercises. These have mostly been used to raise awareness and improve risk management rather than to set capital requirements, partly because climate modelling involves considerable uncertainty.