## clnea2022005

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---

### Overview
- Human-induced climate change, including more frequent and intense extreme events, has caused widespread adverse impacts and related losses and damages to nature and people (IPCC 2022).
- Countries need effective policies to manage risks and harness opportunities from climate change, including risks to economic and financial stability and opportunities for growth and job creation from the transition to a greener economy.
- A key pillar of IMF work is engaging with member countries to evaluate the magnitude of climate-related risk and potential pressure points for the financial system due to physical climate shocks and the transition to a low-carbon economy.

### Role of economic and financial analysis
- Analysis raises awareness of risk, adaptation needs, and opportunities, including the need for:
  - Banks to develop tools to manage climate risks.
  - Financial sector supervisory authorities to adequately supervise climate risk.
- Climate risk analysis informs IMF core activities, including surveillance and capacity development.

### Distinction from standard stress testing
- Climate risk analysis considered by IMF staff is not a standard stress test:
  - Standard stress tests assess bank resilience against regulatory minima using historical macro-financial relationships and plausible historical-based scenarios.
  - Climate risk analysis does not focus on quantifying possible capital needs relative to regulatory minima because of:
    - Uncertainty in climate modeling.
    - Long simulation horizons: largest global physical risk consequences expected over a 30–80-year horizon.
    - Potential for material risks over shorter horizons from extreme events and market revaluation of firms and banks.
- The note focuses on methodologies and illustrates adaptations of FSAP frameworks to incorporate climate risk.

### Extension and improvement of climate risk analysis in FSAPs
- Staff will seek to extend climate risk analysis to more FSAPs going forward.
- The scope of any analysis will be based on an initial assessment of each country’s specific vulnerabilities and materiality of the risks.
- Staff will enhance climate modeling techniques based on the methodologies implemented in the piloting exercise.
- A continuous assessment of climate data sets will be undertaken to ensure access to high quality data.
- Expanding skillsets and technical capabilities will be necessary to fully understand and incorporate the findings of climate science in the framework.

### Cooperation and data usage
- Continued collaboration with World Bank staff on modeling climate risk scenarios.
- Continued engagement with the NGFS to leverage experience from other countries.
- Continued learning from authorities’ climate experts and use of national granular data in the context of FSAP work.

### Application beyond banks and to fragile states
- The methodology focused on banks could be applied to other financial sectors such as insurance companies and mutual funds, noting:
  - For insurance companies and mutual funds, the macro scenario stages would be the same while stress testing methodology for each sector would be different.
  - Investment funds are pass-through structures where the risks are borne directly by the investors.
- The framework could be of value to members through capacity development work.
- Opportunity to provide assessments of physical risk facing financial systems in fragile states, which are relatively more exposed to certain physical risks than other jurisdictions, including in the context of Article IV consultations.

### Purpose and immediate focus
- At this early stage, the note focuses on methods IMF staff are deploying to raise awareness of risks.
- This awareness work will help inform policies to:
  - Enhance risk management and the resilience of the financial system.
  - Support adaptation and transition efforts in the financial sector as a complement to the real sector.

### Role of the FSAP (Annex 1: summary)
- FSAP is a comprehensive and in-depth analysis of a country’s financial sector, conducted jointly with the World Bank in emerging and developing economies.
- To date, more than three-quarters of the institutions’ member countries have undergone assessments.
- FSAP goals:
  - Assess financial sector stability and soundness:
    - Examine resilience of banking and nonbank sectors; conduct stress tests and analyze systemic risks, including links among banks and nonbanks and domestic and cross-border spillovers.
    - Analyze emerging risks, including climate and cyber risks.
    - Examine microprudential and macroprudential frameworks; review supervision and financial market infrastructure oversight; evaluate ability of authorities and safety nets to respond to systemic stress.
  - Assess development aspects:
    - Examine institutions, markets, infrastructure, inclusiveness, legal framework, payments and settlements systems, obstacles to competitiveness, financial inclusion, and access to retail payment digital technology.
    - Examine financial sector’s contribution to economic growth and development, with focus on deepening domestic capital markets in developing and low-income countries.

### Climate risk channels (Annex 2: summary)
- Physical risk:
  - Losses due to increasing frequency and severity of climate-related events (“hazards”) including acute risks (storms, floods, heat waves) and chronic risks (rising sea levels, changes in precipitation).
  - Losses include adverse impacts on assets and resulting financial sector losses, and negative second-round effects on the economy.
  - Climate science data (e.g., IPCC reference scenarios, CMIP) are publicly available but not easily accessible and require climate science expertise; commercial vendors offer higher-resolution, user-friendly datasets.
- Transition risk:
  - Results from changes in climate policy, technological advances, and consumer and market sentiment during adjustment to a lower carbon economy.
  - Staff approach focuses on carbon taxes, both domestic and external, as the main source of transition risk.
  - Representation of transition risk via carbon taxes is used for tractability and is consistent with central bank and NGFS scenario design; other policies can be modeled as carbon tax equivalents.
  - Adverse effects include losses for carbon-intensive industries affected by the carbon tax and second-round effects on the economy.
- Interaction:
  - Physical and transition risks are inter-twined: faster transition reduces temperature increase and physical effects, but economic effects depend on pace and composition of transition. Delays or large divergences across countries could increase economic and financial costs from both risk types.

### Physical risk macro approach — Philippines FSAP (Annex 3: findings)
- Pilot analyzed impact of physical risk on economy and banks using the macro approach; conducted with the World Bank for a typhoon-prone country.
- Four modules:
  - Climate scenarios:
    - Used authority studies to build typhoon intensity and frequency scenarios as a function of the NGFS hot house world temperature scenario.
    - Found number of typhoons would decline but intensity (measured by windspeed) would increase.
  - Damages:
    - Used a catastrophe (CAT) risk model and country-specific exposure and vulnerability data from the Government of the Philippines.
    - Under the given global warming scenario:
      - Damage rate of physical capital for severe typhoons (1 in 100 years event) would rise by 40 percent (damage rate going up from 2.2 percent to 3.1).
      - Damage rate for historically rare (1 in 500 years) typhoons would rise by nearly 70 percent (damage rate going up from 5 percent to 8.5).
  - Macro scenarios:
    - Used damage rate to parameterize depreciation shock to physical capital in a DSGE model calibrated for the Philippines.
    - Shock to capital assumed to generate a productivity shock, amplifying direct impact on capital stock.
  - Banking stability assessment:
    - Standard macro scenario stress testing assessed impact on bank capital via macroeconomic channels.
- Macro-financial result:
  - Historically rare typhoons could reduce GDP by more than 5 percentage points for once-in-100-years typhoons and 14 percentage points for once-in-500-years (at the peak).

### Transition risk — “Climate Minsky moment” (UK FSAP, Annex 4: approach and results)
- Pilot assessed implications of a “climate Minsky moment” where agents price in upfront changes in companies’ prospects from technology and/or policy shocks, leading to market and credit losses.
- Shock definition:
  - Drastic change in expected global decarbonization policies from hot house (“business as usual”) to an “orderly (but ambitious) transition to a low carbon economy,” entailing a sharp steepening of expected carbon price path.
- Timeframes:
  - Simulation horizon: 2020–50.
  - Risk horizon: 2020–25 (risks evaluated at the “climate Minsky point” within the five-year risk horizon).
- Scenario basis:
  - NGFS scenarios: (1) “National determined contributions” (NDCs) as business-as-usual; (2) “1.5°C with Carbon Dioxide Removal” (1.5°C+CDR) or “Net Zero 2050” (NZ2050) as orderly transition scenarios.
- Modeling steps:
  - CGE model (GTAP) used to assess sectoral impact in terms of change in expected sectoral gross value added.
  - CGE output used to assess firm-level impacts via climate-related financial models from a private vendor, affecting operating costs and, for some industries, sales.
  - Shock to expected cash flows led to generalized revision of corporate asset valuations, impacting equity holdings and altering probabilities of default and credit spreads (via Merton approach).
  - Changes in valuations mapped to losses on financial institutions’ holdings of securities and banks’ loans (but not into bank capital).
- Results:
  - A switch from NGFS NDCs to Net Zero 2050 would generate:
    - Credit losses of 3.6 percent, on average, on banks’ corporate loan portfolio.
    - Market losses of more than 4 percent, on average, on banks’ equity and corporate bond holdings.
    - Pension funds losses of 3.5 percent on equity and corporate bond holdings.
    - Insurers losses of 11 percent on equity, and 4 percent on corporate bonds.
- Comparison with Bank of England Climate Biennial Exploratory Scenario (CBES):
  - FSAP exercise is largely complementary to CBES; key differences include top-down vs guided bottom-up approaches, broader coverage (including investment funds and pension schemes) in FSAP sample, FSAP focus mainly on transition risk, and FSAP evaluation of risks within a five-year risk horizon.

### Modeling transition risk in emerging market economies (Annex 5: approach)
- Experimentation with analyzing impact of transition risk on financial sector of emerging market economies, particularly from carbon border adjustment taxes (relevant for large fossil fuel exporters and policies such as the EU Carbon Border Adjustment Mechanism).
- Approach:
  - Applied to nonfinancial firms and banks via micro simulation connected to a CGE model (global recursive CGE models with embedded emissions and climate modules, e.g., ENVISAGE covering 121 countries, 20 regions, and 57 industries).
  - Models derive carbon tax paths, GDP, trade effects, and sectoral impacts consistent with emissions and temperature target paths.
  - Models allow differentiated impact of external shocks on firms’ sales through exports vs. domestic sales (important for CBAM assessment).
  - NGFS approach also considered as an alternative to CGE simulation.
- Firm-Bank (FIBA) extension:
  - Micro simulation framework connected to CGE model to cover granular firm-level data and bank exposures to emission-intensive segments.
  - Modeled outputs include sectoral and macro impacts (GDP, trade); firm-level and aggregated industry-level probabilities of default, losses given default, credit spreads; links to banks’ capital and loss contributions from industries.

### NGFS member institutions conducting climate risk analysis (Annex 6: regional listing)
- Listed NGFS member institutions across regions (Asia and Pacific; Middle East and Central Asia; Europe; Africa; Western Hemisphere) currently conducting climate risk analysis as reported by NGFS (2021a).

*Source: clnea2022005 — INTRODUCTION; CONCLUSIONS AND NEXT STEPS; Annex summaries*

### INTRODUCTION

### INTRODUCTION

### Overview
- Human-induced climate change, including more frequent and intense extreme events, has caused widespread adverse impacts and related losses and damages to nature and people (IPCC 2022).
- Countries need effective policies to manage risks and harness opportunities from climate change, including risks to economic and financial stability and opportunities for growth and job creation from the transition to a greener economy.
- A key pillar of IMF work is engaging with member countries to evaluate the magnitude of climate-related risk and potential pressure points for the financial system due to physical climate shocks and the transition to a low-carbon economy.

### Role of economic and financial analysis
- Analysis raises awareness of risk, adaptation needs, and opportunities, including the need for:
  - Banks to develop tools to manage climate risks.
  - Financial sector supervisory authorities to adequately supervise climate risk.
- Climate risk analysis informs IMF core activities, including surveillance and capacity development.

### Distinction from standard stress testing
- Climate risk analysis considered by IMF staff is not a standard stress test:
  - Standard stress tests assess bank resilience against regulatory minima using historical macro-financial relationships and plausible historical-based scenarios.
  - Climate risk analysis does not focus on quantifying possible capital needs relative to regulatory minima due to:
    - Uncertainty in climate modeling.
    - Long simulation horizons: largest global physical risk consequences expected over a 30–80-year horizon.
    - Potential for material risks over shorter horizons from extreme events and market revaluation of firms and banks.
- The note focuses on methodologies and illustrates adaptations of FSAP frameworks to incorporate climate risk.

*Italic: Source: clnea2022005 - INTRODUCTION*

### CONCLUSIONS AND NEXT STEPS

### CONCLUSIONS AND NEXT STEPS

### Extension and improvement of climate risk analysis in FSAPs
- Staff will seek to extend climate risk analysis to more FSAPs going forward.
- The scope of any analysis will be based on an initial assessment of each country’s specific vulnerabilities and materiality of the risks.
- Staff will enhance climate modeling techniques based on the methodologies implemented in the piloting exercise.
- A continuous assessment of climate data sets will be undertaken to ensure access to high quality data.
- Expanding skillsets and technical capabilities will be necessary to fully understand and incorporate the findings of climate science in the framework.

### Cooperation and data usage
- Continued collaboration with World Bank staff on modeling climate risk scenarios.
- Continued engagement with the NGFS to leverage experience from other countries.
- Continued learning from authorities’ climate experts and use of national granular data in the context of FSAP work.

### Application beyond banks and to fragile states
- The methodology focused on banks could be applied to other financial sectors such as insurance companies and mutual funds, noting:
  - For insurance companies and mutual funds, the macro scenario stages would be the same while stress testing methodology for each sector would be different.
  - Investment funds are pass-through structures where the risks are borne directly by the investors.
- The framework could be of value to members through capacity development work.
- Opportunity to provide assessments of physical risk facing financial systems in fragile states, which are relatively more exposed to certain physical risks than other jurisdictions, including in the context of Article IV consultations.

### Purpose and immediate focus
- At this early stage, the note focuses on methods IMF staff are deploying to raise awareness of risks.
- This awareness work will help inform policies to:
  - Enhance risk management and the resilience of the financial system.
  - Support adaptation and transition efforts in the financial sector as a complement to the real sector.

### Role of the FSAP (Annex 1: summary)
- FSAP is a comprehensive and in-depth analysis of a country’s financial sector, conducted jointly with the World Bank in emerging and developing economies.
- To date, more than three-quarters of the institutions’ member countries have undergone assessments.
- FSAP goals:
  - Assess financial sector stability and soundness:
    - Examine resilience of banking and nonbank sectors; conduct stress tests and analyze systemic risks, including links among banks and nonbanks and domestic and cross-border spillovers.
    - Analyze emerging risks, including climate and cyber risks.
    - Examine microprudential and macroprudential frameworks; review supervision and financial market infrastructure oversight; evaluate ability of authorities and safety nets to respond to systemic stress.
  - Assess development aspects:
    - Examine institutions, markets, infrastructure, inclusiveness, legal framework, payments and settlements systems, obstacles to competitiveness, financial inclusion, and access to retail payment digital technology.
    - Examine financial sector’s contribution to economic growth and development, with focus on deepening domestic capital markets in developing and low-income countries.

### Climate risk channels (Annex 2: summary)
- Physical risk:
  - Losses due to increasing frequency and severity of climate-related events (“hazards”) including acute risks (storms, floods, heat waves) and chronic risks (rising sea levels, changes in precipitation).
  - Losses include adverse impacts on assets and resulting financial sector losses, and negative second-round effects on the economy.
  - Climate science data (e.g., IPCC reference scenarios, CMIP) are publicly available but not easily accessible and require climate science expertise; commercial vendors offer higher-resolution, user-friendly datasets.
- Transition risk:
  - Results from changes in climate policy, technological advances, and consumer and market sentiment during adjustment to a lower carbon economy.
  - Staff approach focuses on carbon taxes, both domestic and external, as the main source of transition risk.
  - Representation of transition risk via carbon taxes is used for tractability and is consistent with central bank and NGFS scenario design; other policies can be modeled as carbon tax equivalents.
  - Adverse effects include losses for carbon-intensive industries affected by the carbon tax and second-round effects on the economy.
- Interaction:
  - Physical and transition risks are inter-twined: faster transition reduces temperature increase and physical effects, but economic effects depend on pace and composition of transition. Delays or large divergences across countries could increase economic and financial costs from both risk types.

### Physical risk macro approach — Philippines FSAP (Annex 3: findings)
- Pilot analyzed impact of physical risk on economy and banks using the macro approach; conducted with the World Bank for a typhoon-prone country.
- Four modules:
  - Climate scenarios:
    - Used authority studies to build typhoon intensity and frequency scenarios as a function of the NGFS hot house world temperature scenario.
    - Found number of typhoons would decline but intensity (measured by windspeed) would increase.
  - Damages:
    - Used a catastrophe (CAT) risk model and country-specific exposure and vulnerability data from the Government of the Philippines.
    - Under the given global warming scenario:
      - Damage rate of physical capital for severe typhoons (1 in 100 years event) would rise by 40 percent (damage rate going up from 2.2 percent to 3.1).
      - Damage rate for historically rare (1 in 500 years) typhoons would rise by nearly 70 percent (damage rate going up from 5 percent to 8.5).
  - Macro scenarios:
    - Used damage rate to parameterize depreciation shock to physical capital in a DSGE model calibrated for the Philippines.
    - Shock to capital assumed to generate a productivity shock, amplifying direct impact on capital stock.
  - Banking stability assessment:
    - Standard macro scenario stress testing assessed impact on bank capital via macroeconomic channels.
- Macro-financial result:
  - Historically rare typhoons could reduce GDP by more than 5 percentage points for once-in-100-years typhoons and 14 percentage points for once-in-500-years (at the peak).

### Transition risk — “Climate Minsky moment” (UK FSAP, Annex 4: approach and results)
- Pilot assessed implications of a “climate Minsky moment” where agents price in upfront changes in companies’ prospects from technology and/or policy shocks, leading to market and credit losses.
- Shock definition:
  - Drastic change in expected global decarbonization policies from hot house (“business as usual”) to an “orderly (but ambitious) transition to a low carbon economy,” entailing a sharp steepening of expected carbon price path.
- Timeframes:
  - Simulation horizon: 2020–50.
  - Risk horizon: 2020–25 (risks evaluated at the “climate Minsky point” within the five-year risk horizon).
- Scenario basis:
  - NGFS scenarios: (1) “National determined contributions” (NDCs) as business-as-usual; (2) “1.5°C with Carbon Dioxide Removal” (1.5°C+CDR) or “Net Zero 2050” (NZ2050) as orderly transition scenarios.
- Modeling steps:
  - CGE model (GTAP) used to assess sectoral impact in terms of change in expected sectoral gross value added.
  - CGE output used to assess firm-level impacts via climate-related financial models from a private vendor, affecting operating costs and, for some industries, sales.
  - Shock to expected cash flows led to generalized revision of corporate asset valuations, impacting equity holdings and altering probabilities of default and credit spreads (via Merton approach).
  - Changes in valuations mapped to losses on financial institutions’ holdings of securities and banks’ loans (but not into bank capital).
- Results:
  - A switch from NGFS NDCs to Net Zero 2050 would generate:
    - Credit losses of 3.6 percent, on average, on banks’ corporate loan portfolio.
    - Market losses of more than 4 percent, on average, on banks’ equity and corporate bond holdings.
    - Pension funds losses of 3.5 percent on equity and corporate bond holdings.
    - Insurers losses of 11 percent on equity, and 4 percent on corporate bonds.
- Comparison with Bank of England Climate Biennial Exploratory Scenario (CBES):
  - FSAP exercise is largely complementary to CBES; key differences include top-down vs guided bottom-up approaches, broader coverage (including investment funds and pension schemes) in FSAP sample, FSAP focus mainly on transition risk, and FSAP evaluation of risks within a five-year risk horizon.

### Modeling transition risk in emerging market economies (Annex 5: approach)
- Experimentation with analyzing impact of transition risk on financial sector of emerging market economies, particularly from carbon border adjustment taxes (relevant for large fossil fuel exporters and policies such as the EU Carbon Border Adjustment Mechanism).
- Approach:
  - Applied to nonfinancial firms and banks via micro simulation connected to a CGE model (global recursive CGE models with embedded emissions and climate modules, e.g., ENVISAGE covering 121 countries, 20 regions, and 57 industries).
  - Models derive carbon tax paths, GDP, trade effects, and sectoral impacts consistent with emissions and temperature target paths.
  - Models allow differentiated impact of external shocks on firms’ sales through exports vs. domestic sales (important for CBAM assessment).
  - NGFS approach also considered as an alternative to CGE simulation.
- Firm-Bank (FIBA) extension:
  - Micro simulation framework connected to CGE model to cover granular firm-level data and bank exposures to emission-intensive segments.
  - Modeled outputs include sectoral and macro impacts (GDP, trade); firm-level and aggregated industry-level probabilities of default, losses given default, credit spreads; links to banks’ capital and loss contributions from industries.

### NGFS member institutions conducting climate risk analysis (Annex 6: regional listing)
- Listed NGFS member institutions across regions (Asia and Pacific; Middle East and Central Asia; Europe; Africa; Western Hemisphere) currently conducting climate risk analysis as reported by NGFS (2021a).

*Source: IMF Staff*

### Annex Table 6.1. NGFS Member Institutions Currently Conducting Climate Risk

### Annex Table 6.1. NGFS Member Institutions Currently Conducting Climate Risk Analysis

### Purpose and placement
- Annex Table 6.1 appears in IMF STAFF CLIMATE NOTE 2022/005, "Approaches to Climate Risk Analysis in FSAPs".
- The annex documents NGFS member institutions that are currently conducting climate risk analysis (title only as provided in the source content).

### Context and related material noted on the page
- The page containing Annex Table 6.1 also includes a References section listing numerous works on climate scenario analysis, climate-related financial risk, stress testing, and macro-fiscal implications of climate change.
- The document header/footer identifies the publication as part of "IMF | Staff Climate Notes" and contains the note label "Approaches to Climate Risk Analysis in FSAPs."

*IMF STAFF CLIMATE NOTE 2022/005 — Annex Table 6.1 (page extract provided)*

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_Source: https://www.imf.org/-/media/files/publications/staff-climate-notes/2022/english/clnea2022005.pdf_