Right direction, wrong equipment: Why transition risks do not fit into regulatory stress tests
The authors of this report explore the challenges of integrating climate-related risks into regulatory stress tests. They demonstrate that supervisory risk assessment frameworks struggle to capture long-term systemic risks, and offer recommendations for developing a ‘long-term risk;’ supervision ‘infrastructure.’
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OVERVIEW
This report explores the potential integration of climate-related risks into regulatory stress tests. The authors analyse the challenges in integrating energy transition risks into the existing supervisory stress-test scenarios, emphasising that it is currently unlikely that such risks will be captured by stress tests.
Integrating transition risks into scenarios
The report explores different ways of integrating transition risks into macroeconomic parameters, asset-class level impacts, sector or sub-sector/commodity impacts. The authors’ findings indicate that transition risks are not material enough, in the short-term, to impact traditional stress-test scenarios. However, at sectoral level, these risks could be relevant. The sectoral details of these scenarios are too granular and expansive for existing stress-testing frameworks, thus making it improbable that supervisory authorities will capture these transition risks.
Barriers to materiality
The lack of incentives to disclose long-term risks and the mismatch of the time horizon of risk models across the investment chain are barriers to materiality. Climate-related risks that are material for physical asset or company are not necessarily priced by financial analysts. The authors recommend devising an infrastructure that can identify and quantify risks that are almost certain, will reflect on the economy and financial markets but are outside of the horizon of present-day risk models.
Conclusion and recommendations
While evaluating and testing financial institutions’ exposure to climate-related risks has become standard practice, transition risks, which could be a source of substantial losses in the banking industry, have not been included in existing bank supervisory stress tests.
The report suggests that assessing energy transition risks is the right direction for supervising authorities, but current stress-testing approaches are inadequate for catching these risks. The authors present possible solutions and recommend the creation of a risk assessment and supervision infrastructure for identifying risks that will impact the economy and financial markets at scale, but are beyond the horizon of current risk models.
The authors recommend developing a risk assessment and supervision infrastructure for identifying risks that will impact the economy and financial markets at scale but are beyond the horizon of current risk models. As part of this solution, the authors suggest monitoring the mispricing of long-term, non-cyclical, non-linear risks such as those related to disruption related to the energy transition. This report underscores the importance of building a framework for testing transition risks and analysing their materiality in order to address ESG concerns.
The report highlights the challenges faced in integrating energy transition risks into the existing supervisory stress-test scenarios and that current supervisory risk management instruments are not equipped to capture long-term systemic risks such as those related to climate change. While climate-related risks are standardly tested by financial institutions, transition risks are not included in existing stress tests. Thus, this report raises an important ESG issue, i.e., the need to define infrastructure that can identify and quantify risks that are beyond the horizon of current risk models.
