Too Soon to Base Capital Requirements on Climate Scenarios

NGFS members do not yet envisage calibrating prudential policies such as capital requirements on the basis of climate scenario exercises.

Central banks are increasingly using climate scenarios to identify, assess and understand climate risks in their economies and financial systems, according to a new assessment of current practice.

Data and skills gaps, as well as differences in methodology, mean that central banks are not yet looking to impose capital requirements on regulated firms – banks, asset managers and insurers – based on existing climate scenario analyses.

The findings from a report – ‘Scenarios in Action: a progress report on global supervisory and central bank climate scenario exercises’ – by the Network for Greening the Financial System (NGFS) form part of its contribution to COP26 in Glasgow next month.

Central banks and regulators are currently using their climate scenario exercises as a means of further understanding climate-related risks, the report said. “Given this emphasis on learning, and in light of challenges posed by data gaps and methodological uncertainties, no members as of yet envisage calibrating prudential policies such as capital requirements on the basis of their exercise.”

But the report suggested higher capital requirements for institutions with higher exposure to climate risks could not be ruled out. “Some members did express interest in this topic and indicated that they may include it as an objective for future exercises,” it said.

The NGFS is a global group of central banks and supervisors which share best practices to contribute to the development of environment and climate risk management in the financial sector, and to mobilise finance to support the transition toward a sustainable economy. Membership covers 95 central banks and supervisors and 16 observers.

The progress report featured 30 members’ climate scenario exercises to date and revealed that the NGFS scenarios – a global set of scenarios and published guidance – are a foundational component in almost all of them. The exercises mainly focused on climate risks to banks’ credit portfolios, with to date, just one NGFS member including climate litigation risk. Around half of the reported exercises involved insurers or other financial institutions.

Central banks surveyed for the report are typically using time horizons longer than 30 years to capture more severe physical risks, while exercises with shorter scenario time horizons aimed to enhance the confidence level of the results and to align with existing supervisory stress tests.

Around two thirds of survey respondents collaborated with external parties such as meteorological and academic institutions, external modelling teams and data providers, and other central banks and international organisations.

Early stages

The NGFS said that as climate scenario analysis represents a relatively new area of activity for central banks and supervisors, there is typically a need for internal capacity building. It warned that it may take time for teams across organisations to become sufficiently versed in climate issues to contribute meaningfully to work on the scenario exercise.

It also identified a number of challenges that needed to be addressed, include data gaps. Doing climate scenario analysis can help generate relevant data and fill some of the gaps, the report acknowledged, but this is a gradual process. In light of these challenges, climate scenario analysis is a difficult task and “should be approached with humility”.

The report suggested that more work needed to be done to make NGFS scenarios more tailored to the specific needs of a jurisdiction.

Objectives of climate scenario exercises ranged from assessing microprudential, macroprudential and economic risks, to developing capabilities both internally and within the broader financial sector. As most NGFS members are indeed conducting climate scenario analysis for the first time, many view developing awareness and capabilities around climate-related risks as equally important to assessing the risks themselves.

“This report highlights the keen efforts of many central banks and supervisors to develop and launch exercises which assess the financial risks and economic consequences that arise from climate change,” said Sarah Breeden, Chair of the macro-financial workstream for NGFS and Executive Director and Member of the Financial Policy Committee at the Bank of England.

“Not only does this report attest to the value of scenario analysis as the leading tool for sizing climate impacts, but it also highlights that the extensive free-to-use package of NGFS scenarios is enabling authorities to take such necessary strides quickly, and so supporting the global transition to net zero,” she said.

Frank Elderson, Chair of the NGFS and Member of the Executive Board of the European Central Bank, added: “This new NGFS report confirms how scenario-analysis and stress-testing can be used in practice to better understand the economic and financial risks from climate change. The NGFS will continue to support central banks and supervisors to incorporate these important analytical tools in their tasks and responsibilities”.

The NGFS said that as climate scenario exercises develop, insights into the financial impacts from transition and physical risks will become increasingly comprehensive, based on a converging set of methodological practices and a growing body of data.

The NGFS and the Financial Stability Board will publish a joint report in 2022 on the implications of possible future climate scenarios for the financial system. The NGFS said it would continue to improve its scenarios with the aim to be as relevant as possible for economic and financial analyses.

Read more articles like this on Regulation Asia’s sister publication, ESG Investor.

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