An overview of recent climate stress exercises in Europe

Introduction

After several exercises carried out by European regulators, and a displayed intention by the Federal Reserve to tackle the climate stress test of the financial system, it is now established that this subject will be part of the risk studies of banking institutions worldwide, and this for several years.

In broad terms, a climate stress test is always expressed as follows.

1. The anticipation of climate change is carried out by researchers, the results of this research being compiled and published by the IPCC. This work determines the physical risk that the global warming may pose to the world.
2. The anticipation of policy responses to this change, to reduce or contain its effects, is also the subject of research, defining response scenarios. This work determines the risk that the transition to a low carbon economy poses to the world.
3. The combination of a climate change scenario and a response scenario impacts the economy in different ways by region and by sector. This impact is assessed in a more or less precise way by macroeconomic models by identifying the "transmission channels" from the climate to the economy.
4. The financial sector can then use all these elements to assess its resistance to these different scenarios. Even if the research is generally already done outside the financial sector, it is important that regulators and banks understand it well, in particular to assess the uncertainty of anticipations.

This article summarizes the recent exercises carried out in Europe.

The Dutch Central Bank 2018 exercise

In 2018, the Dutch Central Bank DNB launched one of the first exercises “An Energy Transition Risk Stress Test for the Financial System of the Netherlands”.

Interestingly, although the Netherlands are particularly exposed to the anticipated sea level rise, the stress test was focusing only on transition: “The economic losses are brought about by policy measures, technological breakthroughs, or a drop in consumer and investor confidence.”
The Dutch exercise considers 4 scenarios, characterized by 2 variables: is there a technological breakthrough allowing the use of renewable energy? and do the policy makers impose an increase on the carbon price of $100 per ton?

Fig 1 – The transition scenarios according to DNB stress-test

Transition vulnerability factors per industry are calculated by DNB based on an assessment of the embodied emissions of the final goods and services in each industry. The study was conducted by DNB itself, considering its knowledge of the portfolio allocation of Dutch institutions.
The impacts were low as the loss of assets were estimated between 1% and 3% for banks.

Fig 2 – Impact on assets as a percentage of total stressed assets per sector, disaggregated by risk driver

The French Central Bank 2020 exercise

In July 2020, the French Central Bank (Autorité de Contrôle Prudentiel et de Régulation) launched the first stress tests that needed to be carried out by banks and insurers themselves, based on assumptions provided by the regulator: ACPR Pilot Climate Exercise.

As for DNB, the focus was on transition: “One of the objectives of the pilot exercise is to measure, over a long-term time horizon, the consequences of scenarios materialising the transition risk on banking balance sheets.”

At the horizon considered (2050), the physical risks are considered to be incorporated in all scenarios, and are not differentiated. In reality, the impact of physical risks is limited to insurers: “we consider the impact of the physical risk on the frequency of and costs associated with extreme climate events on insurance companies, in particular floods, droughts, sea submersions and cyclone storms (for the overseas departments).”

Three scenarios considered in addition to the Business As Usual (BAU) scenario: orderly transition, delayed transition, sudden transition.

It is interesting to note that since the reference scenario is BAU, in which no transition action is taken, and since the physical risks are assumed to be the same in all scenarios, the only measurable cost for the institutions is therefore the transition cost, without any trade-off with the physical risk. The design of these scenarios therefore measures only the risk of action, not the risk of inaction, which delivers an almost climate-sceptic message.

In this scenario, the French Central Bank provided the estimated impacts of transition on economic sectors, as did the DNB in its first exercise.

Most of the large French banks (BNPP, BPCE, Crédit Agricole, SocGen), and insurers (ACM, AXA, CCR, CNP) took part in the exercise.

The results are shared in a separate document released in May 2021.

On the credit risk side, the results show that the cost of credit risk will increase from 12.4 basis points in 2020, to up to 17.2 basis points in 2050 in the sudden scenario. The difference between the orderly scenario and the sudden scenario is only 1.4 basis points, i.e., less than 10%.

Fig 3 – Evolution of the cost of credit risk for the main French banks according to ACPR scenarios

The Bank of England 2021 exercise

In June 2021, the Bank of England published its 2021 Biennial Exploratory Scenario: Financial risks from climate change (designated as CBES).

This exercise was again considering 3 scenarios, focused on transition: no additional action, early action, late action. This is similar to the French Central Bank scenario. However, it is interesting to note that the CBES exercise differentiates the physical risk associated to each of these scenarios.

Fig 4 – Example of the differentiation of the physical risks in the CBES exercise: annual average precipitation