## How Economies and Financial Systems Can Better Gauge Climate Risks

_IMF Blog, January 4, 2023_

## Source details

**Canonical URL:** [How Economies and Financial Systems Can Better Gauge Climate Risks](https://www.imf.org/en/blogs/articles/2023/01/04/how-economies-and-financial-systems-can-better-gauge-climate-risks)

## Other formats

- [Markdown version](/en/blogs/articles/2023/01/04/how-economies-and-financial-systems-can-better-gauge-climate-risks/index.md)
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## Bibliographic details
- Authors: Tobias Adrian, Vikram Haksar, Ivo Krznar
- Published: January 4, 2023

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### 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.*

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## References

- [Financial Sector Assessment Program](https://www.imf.org/en/Publications/fssa)
- [retooled to incorporate climate risk analysis](https://www.imf.org/en/Publications/staff-climate-notes/Issues/2022/07/12/Approaches-to-Climate-Risk-Analysis-in-FSAPs-519515)
- [data gaps](https://www.imf.org/en/Blogs/Articles/2022/08/23/achieving-net-zero-emissions-requires-closing-a-data-deficit)
- [2021 Philippines FSAP](https://www.imf.org/en/Publications/CR/Issues/2021/04/08/Philippines-Financial-System-Stability-Assessment-Press-Release-and-Statement-by-the-50347)
- [United Kingdom FSAP](https://www.imf.org/en/Publications/CR/Issues/2022/02/22/United-Kingdom-Financial-Sector-Assessment-Program-Financial-System-Stability-Assessment-513442)
- [Pierpaolo Grippa](https://www.imf.org/en/Publications/Publications-By-Author?author=Pierpaolo+Grippa&name=Pierpaolo+Grippa)
- [Marco Gross](https://www.imf.org/en/Publications/Publications-By-Author?author=Marco+Gross&name=Marco+Gross)
- [Sujan Lamichhane](https://www.imf.org/en/Publications/Publications-By-Author?author=Sujan+Lamichhane&name=Sujan+Lamichhane)
- [Caterina Lepore](https://www.imf.org/en/Publications/Publications-By-Author?author=Caterina+Lepore&name=Caterina+Lepore)
- [Fabian Lipinsky](https://www.imf.org/en/Publications/Publications-By-Author?author=Fabian+Lipinsky&name=Fabian+Lipinsky)
- [Hiroko Oura](https://www.imf.org/en/Publications/Publications-By-Author?author=Hiroko+Oura&name=Hiroko+Oura)
- [Apostolos Panagiotopoulos](https://www.imf.org/en/Publications/Publications-By-Author?author=Apostolos+Panagiotopoulos&name=Apostolos+Panagiotopoulos)

_Source: https://www.imf.org/en/blogs/articles/2023/01/04/how-economies-and-financial-systems-can-better-gauge-climate-risks_