What are the challenges in performing climate-related stress tests for various asset classes? And what are the emerging approaches and solutions?

In my previous column, I attempted to forecast the risks that will occupy financial risk professionals in 2024. One of those predictions focused on climate risk. And indeed, this issue is firmly on the agenda of financial institutions.

Regulation concerning climate risk is gaining momentum. By the end of 2024, banks are expected to incorporate climate risk drivers into their stress tests. However, challenges persist, such as a lack of approaches or datasets to facilitate the integration of climate risk drivers into credit and various other risk assessments. So, what are the challenges in performing climate-related stress tests for various asset classes, and what are the emerging approaches and solutions?

Physical versus transition risk

Firstly, it is important to distinguish between two main aspects of climate risk: physical risk and transitional risk.

Physical risk entails the risk to physical assets, such as houses (for mortgage portfolios) or assets of companies (for corporate credit or equity portfolios), resulting from extreme weather events such as floods or rising sea levels.

Transitional risk, on the other hand, encompasses the various financial risks arising from transitioning to a greener operational model, such as phasing out fossil fuels or improving energy efficiency of buildings. Such transitions can be extremely costly, potentially undermining the financial position of borrowers or significantly impacting the financial performance of affected companies and industries.