The most common reason financial institutions (FIs) delay climate risk stress testing, or only do the minimum required by regulators, is there鈥檚 no consensus across the industry. Why invest too much internally or bet on any external provider when there鈥檚 no real way to evaluate competing claims of solution benefit?
It鈥檚 true鈥攏o standard has emerged. What is clear, however, is that the more detailed data we can access, and the more granularity we can approach the challenge, the better we will understand the true impact of climate change on an FI鈥檚 balance sheet. It is not enough to simply score the firms it has exposure to鈥攊t鈥檚 equally important for an FI鈥檚 stress testing to incorporate climate risk directly into the valuation of the issuing firm鈥檚 securities.
Human intervention will likely not impact the environment within the 2030 time-horizon (or even longer) to any extent. So, the key challenge for FIs today is to assess how the firms they have invested in will mitigate their business鈥檚 climate change vulnerabilities in the context of varying transition paths to a lower carbon world.
As in any portfolio management context, an FI would surely want to avoid too much climate risk exposure within its portfolio of investments鈥攚hether they be stocks, bonds, loans, etc. Similar to credit risk, managing the concentration risk of various climate-related events across the balance sheet is just prudent risk management.
This is a daunting task for climate risk. Consider that each issuing firm鈥檚 creditworthiness and business prospects can be impacted by a complex interplay of environmental, regulatory, market and firm-specific factors, all in the context of where the firm does business鈥攖he location of its physical assets and the regulatory regimes it must comply with.
The realization of these impacts also depends on the perspective of the FI鈥檚 investment time horizon. Aside from sudden events like floods and wildfires, the portfolio risk over a shorter time horizon is still more likely to be driven by market sentiment and short-term volatility, rather than by climate. In contrast, the portfolio risk over a longer-term horizon will start to be driven by more fundamental business and financial impacts caused by chronic climate changes, which can be mitigated or even amplified by the policy and industry responses to those changes.
However, history suggests it would be a mistake for FIs to treat short-term and long-term perspectives as distinctly different contexts. Previous financial crises have repeatedly demonstrated the assumption of dynamic portfolio rebalancing can fall apart dramatically in the face of market illiquidity and contagion effects. To emphasize that point, the Financial Stability Board (FSB), the international body tasked with monitoring stability for the global financial system, issued a strong warning in January 2025 on the impact of climate change on the global financial system in the short to medium term.1
So, how can one wade through all this complexity and address climate risk meaningfully? One approach is to separate the source of the risk into distinct risk types and treat each independently. For climate risk, it has become standard practice to distinguish transition risk from physical risk and measure each individually.
But that still leaves a great degree of dimensionality and complex risk factor interplay within each of these components of climate risk, even if done independently. In either case, it is still a challenge to determine the individual impact of transition risk or physical risk on a firm鈥檚 creditworthiness and market prospects.
Let鈥檚 look at transition risk. To model a stock or bond with the appropriate level of granularity, we need to consider all the relevant systemic or industry-wide factors impacting the issuing firm鈥攃arbon emission levels, government policy, supply chains, demand curves, etc., as well as all the firm-specific factors鈥攔evenue mix by sector, physical locations, balance sheet structure, ownership networks, etc.
Not surprisingly, the first wave of regulations, such as the EIOPA (European Insurance and Occupational Pensions Authority) 2022 climate stress tests, has simplified the challenge. By allocating securities to groups based on issuing firms that share similar sensitivities to physical impacts and climate policy changes, a 鈥渜uick and dirty鈥� climate risk assessment can be achieved by simply publishing standardized market risk scenarios for each group.
A typical example of this is to group firms by high-level industry sector classifications, such as NACE (Nomenclature statistique des Activites economiques dans la Communaute Europeenne) or equivalent, and to shock risk factors one-by-one to groups of firms that belong to each of those sectors.
However, as presented in our "Unlocking Business Opportunities through Climate Risk Management" blog, FIs that take this approach are forced into a trade-off between grouping at the appropriate level of industry sector granularity versus having an 鈥渆xplosion鈥� of risk factor shocks associated with the proliferation of industry sector subgroups. Too coarse a level of industry grouping means that different industry subgroups with significantly different (and sometimes opposite) sensitivities to various climate risk factors are grouped together and shocked in a similar manner鈥攑recisely the greatest criticism of the first wave of regulatory stress tests.
While re-categorizing the many NACE subgroups into more 鈥渃limate appropriate鈥� umbrella groups can help alleviate the explosion of risk factors, it will never truly address the firm-specific risk factors adequately. For example, many firms do business in more than one industry sub-sector. But beyond that, differences in the technologies deployed by individual firms and their ability to convert them to a lower greenhouse gas emission profile all have an impact on a particular firm鈥檚 specific climate vulnerability.
Addressing physical risk in this manner is even more challenging. It鈥檚 not only necessary to model all the environmental macro factors associated with a particular physical hazard (such as flooding), firm-specific details like the location of their facilities, potential for business disruption, and any mitigation measures in place must also be taken into account. On top of that, there鈥檚 a strong likelihood that different physical risk events like flooding and drought, for example, are not independent. The article describes a good example of a multi-factor methodology for generating stochastic scenarios paths. The methodology integrates climate risk factors consistently and assesses the impact on physical assets.
Therefore, the only reliable way to avoid these challenges, while incorporating as much granularity as possible, is to focus equally on the creation of scenarios and security valuation鈥攁 far more natural place to capture security and issuer-specific details. Our "Overcoming the Challenges of Climate Risk Regulations - A Guide to Climate Stress Test Implementation" whitepaper provides an efficient approach to this challenge.
Market-wide climate factors and their impact on market risk factors鈥攊ncluding industry sector distinction鈥攊s still critical for stress testing purposes, but anything firm-specific would be much more efficiently addressed by a 鈥渧alue adjustment鈥� approach incorporated directly or via a spread or carry curve. This is not dissimilar to the pricing of derivatives in capital markets. Discounted cashflow valuation based on standard industry-wide risk factors is typically the starting point. This is then augmented by various 鈥渧alue adjustments鈥� (xVAs) which incorporate counterparty-specific information such as credit worthiness, funding usage, capital, collateral and more.
To assess the true impact of climate risk on the balance sheet of an FI, it will be necessary to incorporate this level of granularity, particularly if we ever hope to assess the interplay between various physical hazards and the interplay between physical hazards and policy choices going forward.