Sectoral analysis for climate stress tests

Happy to share a recent working paper, "Impact of Climate Scenario Choices on Climate Financial Risk Assessment," with colleagues at the Oxford Sustainable Finance Group, UK Centre for Greening Finance and Investment (CGFI), and Theia Finance Labs. Key takeaways: 1.    Widespread heterogeneity in climate scenario providers and trajectories indicate large uncertainty for financial institutions in assessing corporate climate transition scenario pathways. 2.    This has significant implications for climate financial stress testing that are premised on climate scenario pathways to meet certain temperature targets and policy ambitions. 3.    A consistent, bottom–up, climate financial stress test is applied to 3,419 power companies using different scenario trajectories and provides two main impacts: net present value (NPV) and probability of default (PD). 4.    Five scenarios are compared under a goal of reaching a global average surface temperature increase of below 2°C, and four scenarios are compared under a goal of reaching global Net Zero by 2050. 5.    Distribution of NPV changes under the stress test show that there are significant differences based on the climate scenario. This can impact the assessment of market and credit risk for companies. 6.    Analysis of individual power technologies indicate that the heterogeneity in company performance is technology specific and likely driven by assumptions in Integrated Assessment Models. 7.    Renewable power companies show improvement in NPV under any stress scenario, but there is some disagreement on the extent to which coal, gas, and oil companies show reduction in NPV. 8.    Hydro and nuclear technology power companies show the greatest uncertainty in financial performance (i.e., NPV) depending on the climate scenario being used. 9.    Results of probability of default (PD) change show similarly conflicting results with high variation in a company’s PD, however we observe higher levels of agreement between scenarios compared to NPV change. 10. Further research is needed to address both the uncertainty and assumptions in climate scenario trajectories as they are applied to financial climate risk analysis. #climaterisk #transitionrisk #stresstests #scenarioanalysis #integratedassessmentmodel #powergeneration #netpresentvalue #probabilityofdefault https://lnkd.in/gV2swsNr

𝗧𝗵𝗲 𝗡𝗚𝗙𝗦 𝗷𝘂𝘀𝘁 𝗿𝗲𝗹𝗲𝗮𝘀𝗲𝗱 𝘀𝗼𝗺𝗲𝘁𝗵𝗶𝗻𝗴 𝗯𝗶𝗴— for the first time, we now have 𝘴𝘩𝘰𝘳𝘵-𝘵𝘦𝘳𝘮 𝘤𝘭𝘪𝘮𝘢𝘵𝘦 𝘴𝘤𝘦𝘯𝘢𝘳𝘪𝘰𝘴 tailored for 𝘀𝘁𝗿𝗲𝘀𝘀 𝘁𝗲𝘀𝘁𝗶𝗻𝗴, 𝗳𝗶𝗻𝗮𝗻𝗰𝗶𝗮𝗹 𝘀𝘁𝗮𝗯𝗶𝗹𝗶𝘁𝘆, 𝗮𝗻𝗱 𝗻𝗲𝗮𝗿-𝘁𝗲𝗿𝗺 𝗺𝗮𝗰𝗿𝗼 𝗿𝗶𝘀𝗸. 🔸 This isn't about 2050. It's the next five years, i.e. 𝟮𝟬𝟮𝟱–𝟮𝟬𝟯𝟬. 🔸 This isn't abstract. It's 𝗚𝗗𝗣 𝘀𝗵𝗼𝗰𝗸𝘀, 𝗰𝗿𝗲𝗱𝗶𝘁 𝗿𝗶𝘀𝗸, 𝗶𝗻𝗳𝗹𝗮𝘁𝗶𝗼𝗻, 𝗮𝗻𝗱 𝘂𝗻𝗲𝗺𝗽𝗹𝗼𝘆𝗺𝗲𝗻𝘁. 𝗧𝗵𝗲𝘀𝗲 𝗮𝗿𝗲 𝘁𝗵𝗲 𝘀𝗵𝗼𝗿𝘁-𝘁𝗲𝗿𝗺 𝘀𝗰𝗲𝗻𝗮𝗿𝗶𝗼𝘀: 1.  A smooth transition ("Highway to Paris") 2.  A delayed, abrupt policy shift ("Sudden Wake-Up Call") 3.  Physical risk disasters without transition ("Disasters & Policy Stagnation") 4.  A fragmented world with climate chaos and policy misalignment ("Diverging Realities") These scenarios are a wake-up call for taking short-term climate risks seriously. ➤ Delaying climate action could increase global 𝗚𝗗𝗣 𝗹𝗼𝘀𝘀𝗲𝘀 𝗯𝘆 𝗼𝘃𝗲𝗿 𝟯𝘅, and unemployment spikes by 1.3 percentage points (Sudden Wake-Up Call vs Highway to Paris). ➤ Climate disasters aren’t just regional anymore. Floods, fires and droughts in Asia or Africa can cut European 𝗚𝗗𝗣 𝗯𝘆 𝟭.𝟳%, driven by supply chain exposure. ➤ Credit risk spreads explode in carbon-intensive sectors. In some cases, default probabilities jump by 20–30 percentage points, stressing banks and insurers alike. ➤ Green sectors could lose out if the transition is abrupt, fragmented, or disrupted by physical shocks. 𝗛𝗲𝗿𝗲 𝗶𝘀 𝘄𝗵𝘆 𝘁𝗵𝗲𝘀𝗲 𝘀𝗰𝗲𝗻𝗮𝗿𝗶𝗼𝘀 𝗮𝗿𝗲 𝗮 𝗴𝗮𝗺𝗲-𝗰𝗵𝗮𝗻𝗴𝗲𝗿 ➤ For the first time, compound hazards—droughts, floods, wildfires—are modelled together, showing how climate risk can become systemic through trade, finance, and supply chains. ➤ Monetary policy is now integrated, so climate shocks affect interest rate paths, inflation dynamics, and macroeconomic volatility. ➤ Financial contagion is now factored in. Using advanced modelling, the framework maps how climate-related losses feed into default risk, cost of capital, and sectoral investment flows. ➤ Sector-by-sector and region-by-region outcomes now include asset-level exposure, probability of default, and sovereign bond repricing, offering tools fit for risk management. 𝗠𝘆 𝘁𝗮𝗸𝗲 This release is a step-change in how we understand and model climate risk. These scenarios are critical because they model economic and financial impacts on business over the next five years. A timeline relevant for senior management, boards and shareholders. Because these scenarios capture dynamic feedback loops, sector-specific capital costs, and second-round effects that ripple through the financial system, the risk science is taken to a whole new level. These real-world complexities have been missing from science to date, which is why these scenarios are so critical. #NGFS #NetZero #ClimateRisk _____________ For updates, follow me on LinkedIn: Scott Kelly

📢 Fit-for-55 Climate Scenario Analysis The European Supervisory Authorities (ESAs) and the European Central Bank (ECB) have released a groundbreaking report, "Fit-for-55 Climate Scenario Analysis," assessing the EU financial sector's resilience to climate change under various scenarios. Key Takeaways: 1️⃣ Limited First-Round Impact of Transition Risks, a sudden repricing of assets due to transition risk (a "run on brown") has a limited initial impact on financial stability. 2️⃣ Combining climate risks with adverse macroeconomic factors significantly increases financial institutions' losses, potentially hindering their lending capacity and the green transition's financing. 3️⃣ Banks face the largest losses, primarily due to credit risk, but their capital and hedging positions help mitigate the impact. They also have the potential to contribute to green financing under less severe scenarios. 4️⃣ Insurers and Institutions for Occupational Retirement Provision (IORPs) face moderate losses, mainly driven by changes in fixed-income asset values. Long-duration bond portfolios are particularly vulnerable to interest rate shocks. The report notes that its static balance sheet approach overestimates losses by not considering the impact on liabilities or mitigating hedging strategies. 5️⃣ Investment funds are most exposed to market risk, with equities bearing the effect of initial losses.  6️⃣ Contagion effects and liquidity stresses from initial shocks amplify losses, highlighting the importance of interconnections within the financial system. Opportunities: 📚 Despite challenges, banks show the potential to support green financing, particularly under the orderly transition scenario. 📚 IORPs and Insurers Role in Green Transition: As major long-term investors, IORPs and insurers can contribute significantly to the green transition by increasing investments in green bonds and other sustainable assets. 📚 The exercise provides valuable insights into climate-related vulnerabilities and their concentration, aiding future supervisory actions and risk management strategies. Challenges: ✴️ The report highlights the heterogeneity of data and methodological challenges in capturing all transmission channels of climate shocks. This underlines the need for improved data quality and methodologies. ✴️ Adverse macroeconomic developments amplify the negative impact of climate risks, posing a significant challenge to the financial system's stability. This report serves as a vital tool for policymakers, supervisors, and financial institutions in understanding climate-related financial risks. While highlighting vulnerabilities, it also underscores the opportunity for the financial sector to support the green transition and contribute to a more sustainable future. #ClimateRisk #FinancialServices #Sustainability #GreenTransition #Fitfor55 #Banking #Insurance #InvestmentFunds #ESG #EU