As society braces for the potential havoc a changing climate could induce, it’s vital to gauge the range of shocks that the economy may soon endure. One way to quantify the effects of the potentially systemic shocks that could ripple through the financial system is to administer “stress tests”—a well-designed analytical process that has, for decades, been used by the IMF, World Bank and financial supervisors for detailed scenario planning to prevent future financial crises.
Measuring the Risks
Stress testing for financial resilience to climate risk stands out as an important new tool in a new IMF staff paper. Climate stress testing measures ways in which a climate crisis would affect the financial system, both globally and on a country-by-country level.
Stress tests capture how an initial financial shock, such as a sudden decline in economic growth or a plunge in real estate prices, can be amplified throughout the financial system. This includes linkages between financial institutions and the day-to-day functioning of the economy, between solvency and liquidity problems, between governments and financial institutions, and among financial institutions themselves.
Stress tests have a long and successful record of answering the question of whether financial institutions, such as banks and insurance companies, would be able—even under the most adverse scenarios—to continue providing all-important financial services. Adding climate-related factors to the existing stress-testing methodology would help government and private-sector leaders prepare for the wide range of potential financial shocks that could be triggered by climate dangers.
To maintain their effectiveness, stress tests need to adapt to new risks. Initially, stress tests looked at the resilience of individual financial institutions. The global financial crisis of 2007–09 sparked an emphasis on stress-testing methodologies that aim to quantify risks to the financial system as a whole (so-called “macroprudential” stress tests). Over the years, the IMF has also improved its tools for macro-financial analysis and scenario exercises, extending the stress-testing framework to cover a greater range of threats.
Physical risks arising from damage to property and transition risks arising from changes in policies and technologies affecting the global transition to a low-carbon economy are becoming part of stress testing at the IMF. The newly refined stress tests can provide assessments of the potential impact of such risks on financial stability and economic growth.
The potential physical risks from natural disasters have already been addressed in some IMF stress tests, specifically for small island states such as the Bahamas, Jamaica and Samoa. Natural disasters have been used as shocks that trigger adverse scenarios (e.g., a major hurricane causing property losses and hurting tourism). Direct losses materialize through the destruction or lower value of assets and collateral, which affects the value of financial institutions’ exposures to corporations and households. In some countries, total economic losses exceed 200 percent of GDP—as when Hurricane Maria struck Dominica in 2017. Going forward, stress tests for physical risks will increasingly capture the macrofinancial effects of more frequent and larger natural disasters.
Stress testing for the transition to a low-carbon economy is a new and rapidly evolving area. Transition shocks will likely emerge as the global economy moves away from industries reliant on non-renewable resources, such as the coal industry. Financial institutions could incur losses on exposures to such firms with business models not built around the economics of low carbon emissions. These firms could see their earnings decline, businesses disrupted, and funding costs increase due to policy action, technological change, and shifts consumer and investor behavior. Risks can materialize especially if the shift to a low-carbon economy is abrupt (as a consequence of prior inaction), poorly designed, or uncoordinated globally. Going forward, a key next step in developing stress tests for transition risks will be to capture “second-round” effects—in which a decline in asset prices leads to fire sales, which further depress asset prices, generating a vicious cycle and an amplifying mechanism for an initial shock.
Adding climate-related factors to the stress testing will help policymakers, corporate decision-makers and investors anticipate climate-related threats. By doing so, the IMF and the World Bank can help deliver valuable insights to officials in a wide range of institutions—including central banks, supervisory agencies, think tanks, and academia—to help society prepare for future emergencies that will require a speedy, agile response.