Why the Stress Test is the Tool of the Times

Imagine this: You take out a mortgage to purchase your dream home. But the rate you were quoted has expired, and when you go to renew it, you find there’s been a major hike in interest rates. With this new rate, you’re no longer able to afford your monthly payments. How do you avoid this nightmare situation? The answer is a stress test.

In the simplest terms, a stress test helps individuals and institutions mitigate risk and make better decisions by playing out big economic shocks—such as a major jump in interest rates or a global pandemic—to ensure they have what it takes to weather the storm.

A stress test is a “what if” exercise, where we contemplate scenarios that would pose the most harm to our financial systems and well-being to determine how we can best manage through them. Stress tests are now being applied to future climate change and the financial risks that come with it.

The 2008 financial crisis put the need for better risk planning into sharp relief, especially for financial institutions. It’s no coincidence that we have seen a steady rise in the use of this tool since then.

Today, financial regulators, banks and policy-makers use stress tests to uncover weak points in how financial institutions operate and identify changes that will help buffer them (and our larger financial system and everyone who depends on it) from harm.

What-if applied to climate change

What’s a climate stress test? It is the same what-if exercise, conducted through the lens of different climate scenarios that have diverse and significant financial consequences.

On the one hand, there are physical climate risks. Think, for example, of extreme weather, such as floods, droughts, ice storms or heat waves, that can damage property, disrupt supply chains, increase insurance costs and shut-down operations. In scenarios where global temperatures rise higher, the physical risks increase.

On the other hand, there are also transition risks. These refer to the material impacts of various degrees of climate ambition and action. For example, new or more stringent government policies aimed at further reducing carbon emissions or speeding the pace of change will have different financial impacts on different sectors and companies, depending upon their climate readiness.

Climate scenarios consider both types of risk—physical and transition. Like other types of stress tests, these scenarios are not predictions. Imagining what would happen if interest rates skyrocket is not the same as predicting that they will.

Assessing the shock

Given the established scientific consensus that climate change risks are increasing and the high degree of uncertainty these risks create, climate stress tests are an important tool to assess the sustainability of companies, investments and our financial system overall. And there is increasing momentum behind this practice.

For example, the Office of the Superintendent of Financial Institutions and the Bank of Canada recently released a major report examining four climate scenarios over a 30-year horizon, from 2020 to 2050, that varied in terms of ambition, timing of global climate and pace of global change:

• Baseline scenario: A scenario with global climate policies in place at the end of 2019.
• Below 2 C immediate: An immediate policy action toward limiting average global warming to below 2 C.
• Below 2 C delayed: A delayed policy action toward limiting average global warming to below 2 C.
• Net-zero 2050 (1.5 C): A more ambitious immediate policy action scenario to limit average global warming to 1.5 C that includes current net-zero commitments by some countries.

The results of the analyses were clear.

First, delayed action will lead to higher economic shocks and risks to financial stability. The longer we wait to act, the more drastic and sudden those actions will be.

Second, while every sector will need to contribute to the transition, the analysis showed that “significant negative financial impacts emerged for some sectors (e.g., fossil fuels) and benefits emerged for others (e.g., electricity).”

Third, macroeconomic risks are present, particularly for carbon-intensive, commodity exporting countries like Canada.

The European Central Bank also conducted a climate stress test with similar findings. It determined that climate change represents a systemic risk, especially for portfolios in specific economic sectors such as mining and agriculture and geographical areas such as the Gulf States. 

It also found physical risks will be more prominent in the long run compared to transition risks. The physical risks of climate change on real estate in coastal regions or on supply chains are expected to be greater than the effects of changes in carbon pricing or other policies.

These findings have clear implications for companies and investors. Now more than ever, the business case for prioritizing and evaluating corporate climate resilience is clear, especially as more investors and lenders incorporate climate data into their financial decisions. For example, it is now broadly understood how climate policy changes could abruptly impact a company’s valuation and financial outlook. This makes climate policy foresight critical for corporate leaders and investors alike.

As climate stress tests become common, their findings and implications will reverberate across the entire financial industry. Savvy leaders will watch this conversation closely and take the necessary steps to adapt and thrive.

Ryan Riordan is Distinguished Professor of Finance at Smith School of Business and research director at the Institute for Sustainable Finance, based at Smith. This article is adapted from an essay posted on The Conversation.