Sustainability's Impact on Risk Management Through Climate Stress Testing and Net-Zero Portfolio Simulations

In the wake of a challenging climate risk environment, financial institutions are rethinking their approach to risk management with a heightened focus on environmental, social and governance (ESG) factors.

 Giada Scalpelli

The urgency of this transformation is evident, with the first climate risk losses materializing in banks’ portfolios. Rabobank exemplifies the potential transition risk financial institutions face; the bank downgraded the creditworthiness of its entire EUR 10.3 billion dairy farm loan portfolio in 2022 and moved it into IFRS 9 Stage 2 due to an ambitious governmental net-zero policy aimed toward Dutch farmers.

The urgency of the moment is further driven by heightened expectations from both regulatory authorities and consumers. In combination, these place substantial pressure on banks to reassess and modify their approaches to incorporating climate risk into their business-as-usual risk management processes. The European Central Bank (ECB) already made a number of Supervisory Review and Evaluation Process (SREP) Pillar 2 capital requirement adjustments to banks in 2023 for their lack of progress with climate risk management. In 2024, the ECB plans to expand its tools and apply fines and even more capital add-ons to ensure banks are properly motivated to carry out the needed progress.

“Climate change is the ultimate systemic risk.”

- Sarah Breeden, Executive Director, Bank of England

The Evolution of Climate Stress Testing

The cornerstone of this transformative shift is climate stress testing. The critical tool enables financial institutions to assess their resilience against climate change risks. Unlike traditional stress tests, which primarily consider only financial metrics, climate stress testing extends its reach to wider dimensions, considering environmental factors like exposure to climate-related events (e.g., floods, hurricanes) and social factors such as communities’ vulnerability to climate change.

 Peter Plochan

Additionally, climate stress testing introduces more model complexity, uncertainties and longer simulation time horizons. As the frequency and intensity of climate-related events increase, financial institutions must gauge the potential impact on their portfolios, ensuring they are fortified against the storm of climate-induced risks.

Climate stress testing is not merely a compliance exercise but a strategic initiative to safeguard against a new era of risks. By evaluating the vulnerabilities of assets and liabilities to climate-related shocks, financial firms can identify potential weak links in their portfolios. This proactive approach empowers institutions to anticipate potential risks and challenges and consequently develop mitigation strategies, allocate resources more effectively, and enhance their overall risk resilience. Examples include:

• Identifying and prioritizing investments in climate change resilient sectors, such as renewable energy, sustainable infrastructure and environmentally conscious businesses;
• Promoting sustainable finance practices by offering green bonds, environmentally friendly investment products and loans that encourage clients to adopt sustainable business practices;
• Providing financing options for businesses and communities to implement climate adaptation measures, such as building resilient infrastructure or adapting agricultural practices to changing climate conditions; and
• Innovating insurance products to address emerging climate risks, such as developing policies that cover climate-related damages and losses, and encouraging risk reduction measures.

Net-Zero Revolution: Transforming the Sustainability Game

The winds of change do not stop at stress testing. At the United Nations Climate Change Conference (COP28) in December 2023, almost 200 countries agreed to take additional measures to reach net-zero carbon emissions by 2050. Their collective action to transition away from fossil fuels signals “the beginning of the end” of the fossil fuel era, according to an announcement issued as the conference closed.

The Glasgow Financial Alliance for Net-Zero (GFANZ) is another example showcasing the momentum of collective climate action. GFANZ formed during the COP26 climate conference in Glasgow and includes more than 650 financial institutions from more than 50 countries. In joining the coalition, members signal that they recognize the importance of aligning their investment strategies with the goal of accelerating portfolio net-zero carbon emissions (i.e., financed emissions).

“The road to net zero will be the greatest transformation of our times.”

- Ursula von der Leyen, President of European Commission

Many portfolio pathways lead to net zero, each with a different risk-and-return profile. The challenge for banks lies in finding the optimal portfolio mix path that will lead to portfolio net-zero carbon footprint by 2050, combined with the lowest risks and highest returns along the way under varying macro and climate scenarios. For portfolio managers, carbon is becoming an important portfolio steering measure, alongside the risks and returns.

To identify the optimal pathway, portfolio managers will need to collect more data and do more forward-looking portfolio analytics. That will require them to get better, and smarter, in simulating the impact of their choices on portfolio key performance indicators (KPIs) and key risk indicators (KRIs), which from now on should include carbon footprint indicators and forecasts.

Portfolio managers must conduct a thorough analysis to comprehensively understand the impact of various portfolio decarbonization strategies. Aligning these insights with the overall bank strategy and risk appetite, portfolio managers can make better informed and more strategic portfolio allocation decisions. These decisions, supported by analytical evidence, aim to optimize returns while concurrently achieving carbon targets and minimizing risks. To accomplish this, institutions need to enhance their strategic asset allocation processes by incorporating extensive scenario analysis and portfolio optimization techniques.

“Delivering the net-zero transition will be incredibly hard work.”

- Bill Winters, Group Chief Executive, Standard Chartered Bank

Challenges and Opportunities

Implementing climate risk stress testing and portfolio decarbonization strategies poses challenges for financial institutions. Data limitations, uncertainties in climate models and the lack of standardized methodologies remain significant obstacles. Additionally, there are concerns about potential market impacts and the need for consistent regulatory frameworks to facilitate these practices effectively.

When designing their stress testing and simulation modeling frameworks, banks must be aware of these challenges. It is crucial that they apply healthy skepticism to results generated over a 10-, 20- or 30-year time horizon, especially when relying on limited data and expert judgment models.

Each alternative expert assumption or judgment can significantly impact the final result and this difference is further amplified by the long time horizons. Therefore, banks must gain a better understanding of the impact that alternative modeling assumptions and methodologies have on the final results. To gain this they should assess the sensitivity of the results to changes in the underlying methodology.

One thing is clear: Regulators are increasingly keen to ensure that banks have taken thorough steps to manage and mitigate model risk embedded in their forward-looking simulation frameworks used for climate risk stress testing. Banks must be prepared to demonstrate this commitment.

“Institutions are required to assess the model risk by estimating the potential variations in the climate stress test results under different modeling methodologies or assumptions.”

- Hong Kong Monetary Authority,
Guidelines for Banking Sector Climate Risk Stress Test

However, these challenges also present opportunities for innovation, modernization and collaboration. Advances in climate data analytics, machine learning and scenario modeling can enhance the accuracy and efficiency of both climate and traditional regulatory risk stress testing. For example, latest technology advances allow automated attribution analysis assisting institutions to quickly understand and document the impact of alternative scenarios and strategies and the impact of different assumptions. This ultimately helps the bank to understand and manage model risk.

The focus now is to make ESG and climate considerations a natural part of how the bank operates every day. It’s not just about meeting regulations; it’s about making sustainability a key part of the regular business. This shift aligns with advice from supervisory authorities, who suggest handling ESG and climate in a more integrated way alongside banks’ current activities in the near future.

In this direction, a robust technological framework is essential for financial institutions to tackle climate risk stress testing and portfolio decarbonization. Unlike custom implementations or spreadsheet usage, advanced technologies offer solutions to data limitations and uncertainties in climate models. This not only enhances accuracy and efficiency but also fosters innovation. It allows analysts to concentrate on the modeling and strategic side of the process without worrying about technological limitations, ensuring a more resilient and adaptive financial landscape.

Taking the Climate Challenge Forward

As financial institutions confront the challenges of a rapidly changing climate and evolving societal expectations, the integration of climate risk components into risk management practices is no longer a choice but a necessity. Climate stress testing and net-zero portfolio simulations are not just buzzwords; they are the compass guiding financial institutions through uncharted waters.

These crucial tools enable institutions to identify, quantify and mitigate climate-related risks while seizing opportunities for sustainable investments. Moreover, they support aligning financial decision-making with global efforts to combat the cause and effects of climate change, promoting a more resilient and environmentally conscious financial sector. By embracing these methodologies, financial institutions can not only safeguard their portfolios and generate sustainable revenues, but also contribute significantly to the transition towards a low-carbon future.

The success of this journey hinges on the ability to navigate the complexities of risk management with foresight, resilience and a commitment to sustainability. As the winds of change continue to blow, those who adapt will not only weather the storm but also set sail toward a more sustainable and secure financial future.

Peter Plochan is EMEA Principal Risk Specialist at SAS, a data and AI leader, helping institutions in tackling climate and financial risk challenges. Peter has a Master’s in Banking and is a certified Financial Risk Manager with over 17 years of experience in financial sector risk management. Peter also delivers risk management trainings globally, covering stress testing, enterprise risk management (ERM), model risk, and climate risk management.

Giada Scalpelli is Senior Customer Advisor for Risk Management at SAS. Based in Italy, Giada helps financial services professionals across roles overcome challenges around credit risk, stress testing, environmental, social, and governance (ESG) risk and climate risk. Before joining SAS and after a period abroad in the Netherlands, she graduated in Mathematics at Università degli Studi di Padova with full marks.