How Economies and Financial Systems Can Better Gauge Climate Risks
IMF Blog, January 4, 2023
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Bibliographic details
- Authors: Tobias Adrian, Vikram Haksar, Ivo Krznar
- Published: January 4, 2023
Overview
- Authors: Tobias Adrian, Vikram Haksar, Ivo Krznar
- Date: January 4, 2023
- Central message: With the right tools, policymakers can help to manage the climate risks impacting economies and financial systems.
- Climate risks considered: physical impacts from climate-related shocks (for example, hurricane damage to power grids) and transition risks from moving to a low-carbon economy (for example, costs of new carbon taxes or laws requiring phase-outs of fossil fuels).
Financial risk analysis
- Financial sector authorities can incorporate climate risk analysis into existing supervisory frameworks to better gauge financial stability risks from climate change.
- The IMF’s Financial Sector Assessment Program (FSAP) already examines resilience of banks and other institutions, including with stress tests to gauge systemic risks; these procedures are being retooled to incorporate climate risk analysis.
- Standard stress testing process described:
- Development of scenario-based stress tests for assessing bank solvency.
- Incorporation of adverse macroeconomic scenarios specifically designed for the tests, including elements like economic contraction, rising unemployment, exchange-rate shocks, and falling asset prices.
- Use of those scenarios as inputs to map relationships between macro drivers and risk factors (such as credit risk and interest income) to estimate impacts on bank income and capital.
- Assessment of bank resilience based on whether capital levels fall below regulatory thresholds.
Beyond the standard approach
- IMF’s climate risk analysis currently focuses on measuring and raising awareness of risks rather than quantifying possible capital needs relative to regulatory thresholds.
- Reasons for different approach:
- Complexities of modeling climate risk and its economic impacts over very long horizons.
- Major data gaps.
- Time horizons and uncertainty:
- While consequences of climate change will play out over decades, risks that could arise in the next three to five years are considered in typical stress testing exercises.
- Incidence and impact of extreme events is rising and there is sizable uncertainty over policies.
- First step in IMF climate risk analysis:
- Assess which hazards are most relevant for a country.
- Where climate risks are important, incorporate physical and transition risk into the bank solvency stress testing framework.
- Scenario construction:
- Often starts with temperature and emissions scenarios based on figures from the United Nations Intergovernmental Panel on Climate Change and adapted by the Network for Greening the Financial System.
- Climate scenarios map emissions and temperature scenarios to physical risks (like extreme weather) and transition risks (such as future carbon taxes).
- Scenarios highlight trade-offs between physical and transition risk—the more orderly the transition, the lesser the increase in temperatures and the occurrence of physical climate risk.
Data and projections
- Overall bank-stability assessment measures how physical or transition risks impact the economy and bank capital.
- Physical risks are localized and require new approaches to understand where storms and floods may strike.
- Analysis uses new data and projections of likelihood and impact of different hazards on:
- Physical assets like buildings or infrastructure.
- Economic activity, for example, extreme heat that reduces working hours.
- Applied example: approach used to consider risks to banks from typhoons in the 2021 Philippines FSAP.
- Transition risk assessment:
- Policies to support transition to a lower carbon world shift resources from brown to green sectors, impacting brown sectors’ prospects.
- For financial-sector analysis, IMF assesses impact of carbon taxes (as a proxy for the wide set of policies to foster transition) on individual economic sectors and, where possible, directly on firms’ balance sheets and therefore to banks.
- Assessment includes potential investor reassessment of business values due to unforeseen policy changes affecting long-term earnings; such an outcome is sometimes referred to as a climate Minsky moment and could lead to increases in credit risk today, affecting bank capital.
- Example referenced: this year’s United Kingdom FSAP gauged how firm valuations, and thus credit risk, could be suddenly affected by climate change.
Enhancing the policy framework
- At this early stage, climate risk analysis can:
- Raise awareness about prudent management of climate risks.
- Incentivize banks to improve their risk-management frameworks.
- Inform supervisors about the potential magnitude of climate-related risks in their jurisdictions and clarify transmission channels to the financial system.
- Current supervisory practice:
- Several supervisors and central banks use climate stress tests to measure exposures to related risks.
- These stress tests help understand challenges to banks’ business models, implications for the provision of financial services, and desired policy responses.
- Ultimate goal: climate risk analysis will help financial institutions disclose and manage related risks.
—This blog reflects research by Pierpaolo Grippa, Marco Gross, Sujan Lamichhane, Caterina Lepore, Fabian Lipinsky, Hiroko Oura and Apostolos Panagiotopoulos.