Stress Testing

Climate Stress Testing and Scenario Analysis

Framework for assessing climate-related financial risks including physical and transition risk scenarios.

guide · Climate Risk · advanced · Free

By the Risk Atlas editorial team · Last updated

Climate Stress Testing

Overview

Climate stress testing evaluates the financial impact of climate-related risks on portfolios and institutions over various time horizons.

Types of Climate Risks

Physical Risks

Direct impacts from climate change

Acute:

  • Extreme weather events
  • Wildfires
  • Flooding
  • Storms

Chronic:

  • Rising sea levels
  • Temperature changes
  • Precipitation patterns
  • Resource scarcity

Transition Risks

Impacts from shifting to low-carbon economy

Categories:

  • Policy and legal (carbon pricing, regulations)
  • Technology (disruption, substitution)
  • Market (demand shifts, commodity prices)
  • Reputation (stakeholder concerns)

Climate Scenario Frameworks

NGFS Scenarios

Network for Greening the Financial System

| Scenario | Description | |----------|-------------| | Orderly | Early, gradual transition | | Disorderly | Late, sudden transition | | Hot House | No additional action |

TCFD-Aligned Scenarios

  • Well-below 2°C
  • 2°C transition
  • 3°C+ pathway

Climate Stress Testing Process

1. Scenario Selection

  • Choose NGFS or custom scenarios
  • Select time horizons (short, medium, long-term)
  • Define severity levels

2. Exposure Mapping

  • Identify exposed assets and counterparties
  • Sector and geographic concentration
  • Physical location analysis

3. Impact Assessment

Physical Risk:

  • Asset damage/impairment
  • Business interruption
  • Supply chain disruption
  • Insurance costs

Transition Risk:

  • Stranded assets
  • Credit quality deterioration
  • Market value changes
  • Operating cost increases

4. Financial Impact

  • Credit losses
  • Market losses
  • Operational impacts
  • Capital implications

5. Strategic Response

  • Portfolio adjustments
  • Risk mitigation
  • Product development
  • Engagement strategies

Data Challenges

  • Limited historical data
  • Long time horizons
  • Complex causality
  • Uncertainty in projections
  • Granular exposure data

Regulatory Context

  • ECB climate stress test
  • Bank of England CBES
  • APRA climate risk guidance
  • Fed climate scenarios

Best Practices

  • Iterative approach
  • Multiple scenarios
  • Sensitivity analysis
  • Governance integration
  • Transparent disclosure

Tags: climate, ESG, TCFD, physical risk, transition risk

More in Stress Testing

  • Liquidity Stress Testing — Framework for assessing liquidity adequacy under stressed conditions including LCR, NSFR, and survival period analysis.
  • Reverse Stress Testing — Methodology for identifying scenarios that could cause business failure and developing appropriate risk mitigants.
  • Stress Testing Framework for Financial Institutions — Guidelines for developing and implementing stress testing programs, including scenario design, impact assessment, and capital adequacy analysis.

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