Stress testing can help firms identify and mitigate risks, but climate risk is an emerging area of research and it can be difficult to know where to start. Sonia Shah takes a looks at scenario planning.
As one of four key areas of interest, the Prudential Regulation Authority (PRA) expects firms to conduct scenario testing to assess climate risk resilience and use them to support future strategy and risk management processes. You should test your resilience against both short-term scenarios, due to transition risks, and long-term scenarios, due to physical risks. The internal capital adequacy assessment process (ICAAP) or own-risk and solvency assessment (ORSA) can be useful frameworks to identify the materiality and sensitivity of climate risks.
In its July Dear CEO, the PRA noted that scenario analysis hasn’t been integrated into broader risk assessments as yet. This is probably because the overall climate change risk management approach is still a work in progress, and firms are still figuring out how to measure and report on climate risk. Once those processes are in place, it will also take time to embed climate change as a cross-cutting risk across the firm.
Transition climate risk versus physical climate risk
Climate risk may emerge due to physical or transition risks, and you should consider both direct and indirect factors when scenario testing. Direct physical risks might include a loss of asset value due to a severe weather event, whereas an indirect physical risk may include long-term climate change leading to a drop in housing prices in that region.
Looking at the transition risks, direct risks include stranded assets due to low carbon requirements, while indirect risks include a drop in demand for higher carbon problems. Differentiating between these can help identify emerging risks and understand the interplay between them. Establishing consistent terms of reference can also aid communication, measurement and reporting.
Using existing climate risk scenarios
A number of think tanks and industry bodies have created climate change scenarios, and the Climate Financial Risk Forum (CFRF) has released guidance to help firms make use of these scenarios for better long-term strategic planning.
The CFRF’s guidance looks at three key areas:
1 Identify objectives, resources and exposures
This includes setting the objectives of the exercise, identifying available resources and agreeing the budget. Firms should also analyse their risk profile to determine their climate change exposures and material risks for use as the foundation to build the scenario.
2 Choose scenarios, risk metrics and data
Firms should use the above information to choose their scenarios and determine the right metrics and impact assessment tools to apply. Among other areas, firms should consider applicable time horizons, the scope of the analysis, and both macro and micro impacts.
3 Developing financial metrics
The next step is working out how to convert the data into a financial metric, or something meaningful for reporting and decision-making purposes. CFRF also notes the potential difficulty firms may face when identifying mitigating controls, due to the long time scales involved.
Many firms may prefer to create their own climate scenarios, or further build on an existing one, and the CFRF also offers good tips to better understand the development process.
Developing a bespoke climate risk scenario
Scenarios should consider a range of extreme, yet plausible outcomes, and understanding the thought process behind them can inform how existing scenarios are used or be the starting point for a bespoke scenario. Firms can build their scenario using one or all of the below components.
Looking at how factors such as population, GDP and urbanisation will affect behaviours and energy use over time, and the consequent impact on physical climate risks. Scenarios should span outcomes for both widespread sustainable practices and continued reliance on fossil fuels.
Reviewing the role technology will play in reducing carbon emissions, including the potential for low-cost alternatives for industry or transport. Scenarios should include any assumptions about emerging tech, the speed of adoption and the impact this may have on physical and transition risks.
Climate risk policy landscape
Assessing green policies as transition risks, including the scale and speed of legislation, how soon it’s applied and how well international approaches align. Scenarios should also consider significant-but-gradual interventions and outcomes without any policy intervention.
Looking at greenhouse gas emissions, including concentrations, geographical distribution, and the physical impact on climate change. Scenarios should consider a range of temperature changes up to the Paris Agreement target of no more than 2ºC above pre-industrial levels, to extreme temperature changes based on high emissions.
Scenarios can be based on one of the above strands or looked at collectively, considering the interaction between them.
Getting started on climate risk management
Stress testing for any type of risk can be tricky. Scenarios should typically be severe but plausible. There may be a tendency to discount plausibility because it can’t be seen in historical data, and lack of imagination can be a limiting factor. This issue is potentially heightened when it comes to climate change because it’s a new area of research and there is no historical precedent for it.
Physical climate change, combined with the scale of action needed to curb it, will impact on your operating models, supply chains and financials. Over time, firms may experience cumulative losses on their balance sheets, which could affect capital buffer requirements and liquidity.
The risk of financial shock is greater if the transition starts later and governments apply more stringent policies to catch up. The extended time frames are one of the areas where firms may struggle and it can be difficult to effectively identify risks over such a long time span, and to know what controls to put in place and when.