The Predictive Power of Stress Tests

to Tackle Climate Change

Proposal title goes here |
 Section title goes here

Contents

Foreword04
1.Introduction to climate risk assessment in the banking sector 05
Climate-related risk channels 05

Growing agenda on climate-related risk at international level 06

Regional initiatives 07

Asia/Pacific: 08

2. Current risk assessment tools used by banks 10

Carbon footprint and budget approaches 10

ESG heatmaps 11

Sector Policies 11

Stress Test Methodologies 11

Existing Internal Capital Adequacy Assessment Processes (ICAAP) 13

Step by step approach to climate

stress-testing15

3.Building an appropriate climate stress testing framework in the scope of

corporate loans 15
Step 1 - Portfolio Analysis 15

Step 2 - Scenario Selection 16

Reference Climate Scenarios 17

Step 3 - Quantification via Stress

Test Modeling 22

Step 4 - Calibration 22

02
 Proposal title goes here |
 Section title goes here

Data requirements related to climate risk assessment 22

Internal data 23

External data 23

Use-Case in the Automotive Sector 24

4.Enhancing climate-related governance 25

Annex: Implementation of the TCFD recommendations – holistic project approach 27

How can Deloitte help? 27

Contacts30

Authors30

03
The Predictive Power of Stress Tests to Tackle Climate Change |
 Foreword

Foreword

Climate change has become observable in leveraging existing approaches and is a need for more comprehensive
every continent and has started to influence transforming methodologies is a core part methodologies.
national economies. The complexity of establishing climate-related exposures. To
• Stress test frameworks leverage forward-
of climate change poses tremendous exhaustively build a climate-related plan of
looking scenarios to outline the financial
challenges for all industries. In the era of action, financial institutions must go further
impact of climate change, and the output
increased global warming, we must make in climate scenario analysis and climate
can be used in other processes, including
headway with climate-related analysis stress test methodologies to provide a
strategic decision making. A use case we
to quantify its material impacts. Building ‘what-if’ analysis reflecting potential
conducted on the automotive industry
projections using plausible trajectories is future conditions.
portrays the material shifts of risk-related
essential not only to measure risks, but
KPIs due to climate change.
also to seize opportunities in the transition We are in contact with banks from all
towards a low-carbon economy. over the world, actively discussing the • The success of climate stress test
implementation of climate stress test implementation depends on effective
Increasing the pace of the low-carbon frameworks, the level of progress in terms change management and governance.
transition relies on the decision-making of climate scenario development and
processes of economic actors. As the governance which needs to be applied in Insights are globally valid, as the nature of
impacts of climate change on the economy relation to climate risk assessment. The core the problem and related challenges concern
and society increase, the importance insights of this paper are the following: every country, and collective action needs
of developing informed and strategic to be taken to exhaustively understand
• Financial institutions have an important
responses becomes fundamental to deal climate risk and opportunities. This report
role to support the low-carbon transition
with the associated uncertainty related to will provide further insights on the topic of
and the starting point is to identify
climate change. Consequently, climate risks climate risk assessment, yet one thing is
climate-related risks and opportunities.
have risen to the top of the agenda for the certain: climate risk assessment and climate
financial industry. Financial institutions have • The development of a climate stress test stress tests for the financial system are
a significant responsibility to take action will become a regulatory requirement in emerging in order to make uncertainty
against climate change, and the urgent the years to come, therefore a quantitative more certain.
assessment of climate risks is necessary assessment using advanced analytics
to make the right decisions. Banks have an is needed. Current climate assessment Anna Celner
important role to play. tools do not adequately cover the impact Global Banking & Capital Markets
of transitional and physical risks, there Practice Leader

04
 The Predictive Power of Stress Tests to Tackle Climate Change| 1.Introduction to climate risk assessment in the banking sector

1.Introduction to
climate risk assessment
in the banking sector
The science of climate change has been Climate change is perceived to generate the Therefore, climate change introduces
actively researched over the past decades. most significant risks to the global economy2 different risks that can affect the stability of
As scientific consensus has emerged and According to the World Economic Forum’s the financial system, especially for financial
the understanding of climate change 2020 Global Risks Report, climate related institutions. Even though climate risk could
has improved, the complexity and the global risks ‘extreme weather events’, ‘failure become a global and systemic financial
uncertainty of the issue has developed. The of climate-change mitigation and adaptation’ risk for financial institutions4, it is poorly
frequency of abnormal natural phenomena and ‘natural disasters’ are classified as top understood by financial institutions.
has increased globally and climate change three risks in terms of likelihood. According The urgency of assessment regarding the
has emerged as a major disruption factor in to the results of the Global Risks Perception non-linear, unpredictable and irreversible
today’s economy. The OECD has announced Survey conducted by World Economic nature of climate change requires the
that, in the absence of mitigation actions by Forum, they are considered more likely to creation of a comprehensive climate risk
2100, global GDP could decrease by up happen than data fraud and cyber-attack assessment approach. Banks should
to 12%1. risk in the scope of global risk 3. In terms develop an exhaustive methodology
of both likelihood and impact, climate- such as climate stress testing, which
related risk is considered a top risk, which will enable financial institutions to assess
demonstrates the need for a climate climate risks to support and seize
risk assessment. opportunities from the transition.

4.0 Clima Climate-related risk channels

W f
Climate-related financial risk can have an
Biod impact on financial stability through three
Ext
W se
es
types of risks:
Info
orma Naturral dis
sasters
s
Cy
Cyberattacks
• Physical risks arising from extreme
di rs
meteorological and climatological events;

• Transition risks arising from the transition

failure

3.5
F
Fin
3.47
averaage to a low-carbon economy;

• Liability risks which are triggered by the

Sttat
tate collapse increased compensation paid to economic
Adve
A
Adv
d

actors affected by climate change.

E

As a primary assessment of climate risks,

3.0
Failure of
urban planning
both types of climate risks should be
included in analyses. When liability risks
Impact

Illicit
are substantiated based on the results of
2.5 3.0
3.31
3.5 4.0
plotted
climate change-related lawsuits, they should
area

be also included in scenario-based

average
Likelihood 5.0

climate analysis.
1.0 5.0

1 OECD (2016). The Economic Consequences of Climate Change

2 The Global Risks Report (2020). Retrieved from https://www.weforum.org/reports/the-global-risks-report-2020
3 An uncertain event or condition that, if it occurs, can cause a significant negative impact for several countries or industries within the
next 10 years.
4 AFEP (2018). Shift Project Report on Climate Risk Analysis

05
The Predictive Power of Stress Tests to Tackle Climate Change| 1.Introduction to climate risk assessment in the banking sector

Overview of climate Types Origin of the Risk Sector Examples Importance

risks

Acute Risks A physical risk is the risk Energy-related sectors: The unpredictability related
resulting from extreme Reduced output, damage to extreme events in terms
Physical Risk

Chronic Risks
events due to climate to infrastructure, changing of time frame, frequency and
change. seasonal demand and magnitude increases the
increased electricity losses due disruptive impact of
to the increased frequency of physical risks.
extreme events

Policy and Legal Risks Climate risk resulting from Energy-related sectors: Risks The speed of socio-economic
mitigation challenges as associated with GHG emission responses significantly affects
Technology Risks
societies decarbonize. To reduction policies such as the impact of transition risks,
Transition Risk

Market Risks stimulate a low-carbon carbon taxation, constraints on they are material even in most
transition, governments consumption to support the sustainable climate scenarios.
Reputation Risks
will need to take action low-carbon energy transition.
which will naturally
Agriculture sector: Risk arising
impact the economics of
from policies aimed at changes
borrowers.
in land-use and farming
practices.

Effective climate risk-related portfolio Climate Change (IPCC). Moreover, IPCC the interest of quantification of climate-
management relies on addressing provided many reports on scientific work for related risk assessment.
physical and transition risks. Considering climate-related policymaking, which includes
climate-related exposures in a quantitative giving notice on the increasing global Momentum towards quantifying climate
framework is the most prominent way to average temperatures. The IPCC predicted risks in the financial sector has been
embed climate risks in strategic decision- that, if action is not taken, temperatures will established with the help of private and
making processes and ensure successful exceed the Paris Agreement target as early public stakeholders, research institutions,
portfolio management. as 2030.6 business intelligence firms and think tanks,
which are working actively on climate
Growing agenda on climate-related risk Climate risk assessment continued to risk assessment. Even though there were
at international level gain popularity in the scope of climate numerous reports published by many
The ‘Tragedy of the Horizon5 ’ started to disclosures with the establishment of actors including regulatory authorities,
be broken after the COP 21, which led to industry-led group Task Force on Climate- academic institutions, NGOs, think tanks,
an international climate agreement -Paris related Financial Disclosures (TCFD) in 2017, etc., the subject of climate risk assessment
Agreement - which aimed to keep global as well as increased regulatory momentum related policies remained vague and in the
warming below 2°C following analysis regarding climate change-related issues. form of recommendations as they aimed to
provided by the International Panel on Improved disclosure led to an increase in introduce climate risks and facilitate

5 BIS (2015). Mark Carney: Breaking the tragedy of the horizon – climate change and financial stability https://www.bis.org/review/
r151009a.htm
6 IPCC (2018). Global warming of 1.5°C. An IPCC Special Report on the impacts of global warming of 1.5°C.

06
 The Predictive Power of Stress Tests to Tackle Climate Change |
 1.Introduction to climate risk assessment in the banking sector

their integration. Initial methods have Regional initiatives

been developed by institutions to move Europe:
forward with the climate risk assessment,
• In 2016, the European Systemic Risk Board
which focused on methodologies similar to
published the report ‘Too late, too sudden:
stress tests of financial institutions. Stress
Transition to a low-carbon economy
tests are now considered key elements
and systemic risk’, to demonstrate the
to understand, quantify and forecast the
potential impacts of the transition to a
financial impact of climate risk in order
low-carbon economy within its benign
to assess physical and transition risks in
scenario and an adverse scenario. The
different plausible scenarios.
report signals the arrival of ‘carbon stress
tests’ in the case of material climate-
Large economies are starting to invest three adverse climate scenarios, following
related systemic effects and highlights the
in research on robust forward-looking the reports of NGFS and ACPR which will
importance of research and consultation
approaches to establish climate-related be published in the first quarter of 2020.
to reconfigure policies.
decision making to decrease the uncertainty The tests will consider multiple modeling
surrounding the effects of climate change • England: The Prudential Regulation horizons such as 2025, 2030 and 2040,
at local and regional levels7. That is the Authority (PRA), which is the financial which are significantly higher than current
reason why central banks started looking services regulatory body of the United 3-year time-horizons of stress tests (see
into the assessment of climate-related risks Kingdom, announced that exploratory section 2.1). The tests are expected to
to measure the resilience of the economy stress tests will be set for insurers and consider physical and transition risks
on a regional level. For that purpose, the banks to examine the UK financial system’s aggregated on a sectoral and geographical
Network for Greening the Financial System capacity to withstand climate-related risks, level.
(NGFS) was established by the central bank including physical and transition risks.
• The Netherlands: The central bank of the
of France (Banque de France) in 2017 to Currently, exploratory climate scenarios
Netherlands, De Nederlandsche Bank
bring together central banks to analyze the have been added to the 2019 Insurance
(DNB), performed an energy transition
transmission channels of climate-related risk Test. According to the PRA discussion
risk stress test exercise that includes
and to develop best practices. paper published in December 2019, the
a stress test in risk management, and
biennial exploratory scenarios for banks
concluded on the existence of an impact
In the following year, NGFS published will be launched in the second half of 2020
on the assets of Dutch banks, insurers and
the report on ‘A Call for Action’ which and the results will be published in 20218.
pension funds. According to the stress test
ignited collective action by central banks, Climate risk modeling will be conducted
it conducted, there are substantial losses
supervisors, and policy-makers to integrate on 30-year horizons and the exercise will
for Dutch banks due to climate change.
climate risks in financial stability monitoring include three scenarios which depend on
and supervision. the speed of the policy action (early policy, • National stimulation was supported by
late policy, no additional policy scenarios). European-level action. The European
Commission published guidelines on
• France: In the last quarter of 2019, in Paris,
reporting climate-related information
the central bank of France (Banque de
while funding a significant amount of
France) announced the arrival of climate
institutions working in the climate risk
change stress tests for French banks and
assessment field. The European Central
insurers in which financial institutions
Bank president highlighted the importance
would be stress tested against two or
of central banks in mitigating global

7 OECD (2017), Investing in Climate, Investing in Growth

8 Bank of England (2019). Retrieved from https://www.bankofengland.co.uk/paper/2019/biennial-exploratory-scenario-climate-change-
discussion-paper

07
The Predictive Power of Stress Tests to Tackle Climate Change| 1.Introduction to climate risk assessment in the banking sector

warming, and assured the European North America: Asia/Pacific:

Parliament by stating that the discussion
on central banks’ role is considered
a priority. Europe cannot achieve its
2030 goals without urgent action
during the next 10 years, and the
financial community will play a major
role in promoting sustainable stability.
European supranational organizations
are therefore working actively in view
of adopting a long-term EU strategy
for climate action in 2020, which is
observable in the European Banking
Authority’s Action plan on sustainable
• Canada: In its 2019 Financial System
finance. The plan clearly states that banks
Review, Bank of Canada listed climate
should identify their vulnerabilities to
change among the top concerns for the
climate-related risk and quantify the
economy. Bank of Canada announced
relevance of the exposures that could be
a plan to integrate climate shocks, and • Australia: The Australian Prudential
affected by physical risk and transition risk.
started working on ways to apply a stress Regulation Authority and the Reserve
• EBA is developing a climate risk test to assess resilience. Bank of Australia are expected to adopt
assessment methodology to identify a series of stress tests to measure the
• USA: The USA initiated a withdrawal from
banks’ vulnerabilities and to quantify impact of policy shocks related to climate
the Paris Agreement. Alongside this, a
the exposures which will be impacted change (e.g., potential policies to limit
senate bill was introduced9 to make the
by physical risks and transition risks. emissions).
Federal Reserve study climate-related
The aim is to help financial institutions
risks and their impact on the financial • China: Bank of China adopted a
to understand and conceptualize their
system. The Climate Change Financial Risk macroprudential framework that gives
climate risks.
Act will lead the central bank to establish incentives to banks to finance green
a union between climate scientists and activities, and work on climate stress tests
economists, in order to make progress is expected.
with climate change scenario analysis and
• Singapore: The Monetary Authority of
financial stress tests. The Fed signaled the
Singapore has announced key measures
incorporation of climate change, which
to promote green finance, and mentioned
will be taken into account when setting
climate-related scenario tests in the
monetary policy.
Financial Stability and Stress Testing
Report of 2019 in order to measure the
impact on general insurers

• There is undeniable worldwide regulatory

pressure on banks in terms of assessing
climate risks. On each continent, different
levels of policy actions are emerging.
According to PRI’s The Inevitable Policy

9 Climate Change Financial Risk Act of 2019 (2019) Retrieved from: https://www.schatz.senate.gov/imo/media/doc/Climate%20Change%20
Financial%20Risk%20Act%20of%202019.pdf

08
 The Predictive Power of Stress Tests to Tackle Climate Change |
 1.Introduction to climate risk assessment in the banking sector

Response project, policy announcements Therefore, in general, some banks can

will accelerate between 2023 and 202510. be more vulnerable to climate risks than
The development of a climate stress test others. For instance, within the scope of
will likely become a regulatory requirement corporate loans, banks in underdeveloped
in the years to come, and it is expected to countries have some disadvantages since
be included in the next stress test exercise there are fewer corporates assured and less
of the European Central Bank. Therefore, Nationally Determined Contribution (NDC)12
the bottom line is that banks need implementation, which increases the impact
guidance and an exhaustive methodology of climate risks. Nevertheless, banks are
to assess climate risk using largely diversified in different sectors, and
advanced analytics. successful portfolio management decisions
can help financial institutions to seize
All economic figures are affected by climate- opportunities if they identify, evaluate and
related risks; banks are impacted in a build a strategy according to climate risk
particular way since through loan-related assessment. Financial institutions, especially
activities, banks are linked to many sectors banks, are a vital element for making
which can be vulnerable to the physical and progress with risk assessment.
transition risks imposed by climate change.
In addition to the regulatory spotlight as
climate-related risks increase each passing
year, incorporating the assessment of
climate-related systemic risks has started
to receive more attention by financial
institutions, which is demonstrated by
numerous recent initiatives related to the
topic.11 Climate risks’ impact broadly differs
depending on banks’ portfolio management
strategies and the socio-economic conditions
in which they operate.

10 UNPRI (2019). Retrieved from https://www.unpri.org/climate-change/the-inevitable-policy-response-policy-forecasts/4849.article

11 Deloitte (2019). Climate Risk: Regulators sharpen their focus
12 UNFCCC definition: Nationally determined contributions (NDCs) are at the heart of the Paris Agreement and the achievement of these long-
term goals. NDCs embody efforts by each country to reduce national emissions and adapt to the impacts of climate change

09
The Predictive Power of Stress Tests to Tackle Climate Change |
 2. Current risk assessment tools used by banks

2. Current risk
assessment tools used
by banks
A typical risk management approach Banks’ lending, market portfolios and • Frameworks which assess the impact of
consists of four stages: risk identification, allocation of asset classes constitute an financial institutions on climate change;
risk evaluation (or measurement), monitor important part of bank balance sheet
• Frameworks which assess the impact of
and possibly reporting on the risk. The management. Therefore, it is essential
climate change on portfolios.
approach should take into account the to review the existing risk management
potential guidance of regulatory authorities. frameworks of banks to understand when
Alignment-related tools to reduce
The aim is to assess the likelihood of the and how to add a climate component.
institutions’ carbon footprint have
risk playing out, to judge the magnitude
increased the recognition of transition
of the material impact on the institution’s Carbon footprint and budget
risks. Specifically after the creation of
portfolio, to estimate the likely timeframe approaches
climate-related reporting frameworks
and duration over which the risk plays out As financial stability is threatened by climate
and the establishment of the TCFD (see
and the velocity with which corresponding change, stakeholders have engaged more in
annex), many banks started to make
materialization can be expected, noting climate risk assessment within the scope of
progress on reducing their emissions.
that with some risks (like cyber) the risk risk management. The earliest frameworks
However, these frameworks - which mainly
arrives suddenly and strikes with immediacy, have been developed to ensure that
consist of scenario-related targeting and
and other risks - such as macroeconomic financial institutions start taking climate
carbon footprint alignment tools - do not
downturns - a slow-burning impact can risks into account. Climate risk assessment
adequately cover the impact of transitional
be expected. frameworks can be categorized into
and physical risks and are currently used
the following:

Simplified typology of decision-making processes in the context of traditional risk-related banking activities 13

Front Office Functions Risk Management Processes

Banking Portfolio Lending Making provisions for losses regarding IFRS 9 standards

Setting a loan limit

Changing the composition of a bank Checking portfolio compliance with risk appetite
loan portfolio

Market portfolio Increasing or reducing a position Setting an investment limit

Changing the composition of a Checking portfolio compliance with risk appetite

market portfolio

Assets and Liabilities Defining the optimal allocation between Checking the institution’s solvency (compliance with the risk appetite
major asset classes framework and the regulatory ratio)

Defining the institution’s optimal Checking the institution’s liquidity (compliance with the risk appetite
financing framework and with the LCR and NSFR regulatory ratios)

Checking compliance with stress tests (internal and regulatory)

13 I4CE (2019). For another approach to climate risk in finance: Taking uncertainties fully into account

10
 The Predictive Power of Stress Tests to Tackle Climate Change |
 2. Current risk assessment tools used by banks

in internal operations. They rarely cover run considering the EU taxonomy for ESG which are considered environmentally and
investment and financing activities (so-called risks in this mapping. In particular, heatmaps socially sustainable.
scope 3 emissions) can serve to identify ESG risk concentrations
in existing portfolios. Defining sector policies is a way that banks
The Science Based Target initiative (SBTi) is take appropriate measures to meet their
a joint initiative between Carbon Disclosure Re-insurance companies issue Catastrophe sustainability standards. Sector policies
Project (CDP), UN Global Compact (UNCG), bonds (CAT) and insurance-linked securities evolve over time depending on regulations,
World Resources Institute (WRI) and the (ILS)to hedge their ESG risks, while investors on discussions made between financial
WWF. It allows companies to develop a in such securities are ESG risk takers. Since institutions and their various stakeholders.
greenhouse gas emission reduction target to the underlying ESG risk factors are not Currently, banks’ common sector policies
limit global warming well below 2°C, which is tradeable, the valuation of these securities is revolve around setting targets to encourage
consistent with the recommendations made based on the real-world probability measure the financing of climate-friendly sectors and
by the science community. Target setting rather than the risk neutral adopting policies to exit sectors which have
elements consist of transforming the carbon probability measure. the most negative impact on climate change.
budget or GHG budget, when applicable, to For instance, many banks have stopped
an emissions scenario, and represents an ESG risk-based methodologies fall short funding coal and other industries. However,
allocation of the available carbon budget. in creating quantitative results which can as climate risks are not integrated effectively
Targets are marked out by scenarios to be applied to multiple risk management in risk assessment methodologies, portfolios
establish key benchmarks and the minimum processes and strategic decision making. which are more exposed to physical and
ambition. A sector-based approach is being Assessing financial risks from climate change transition risks are not yet identified. Banks
developed to increase target granularity. The is an intricate process, therefore new tools need to go further in identifying sectors
aim is to be aligned with today’s necessities and approaches such as climate stress tests and sub-sectors which are more sensitive
(e.g., Paris Agreement goals) and to help need to be developed to systematically to climate risks. Depending on the nature of
companies gain a competitive advantage in assess physical and transition risks. the portfolio, these sub-sectors can
the low-carbon transition. be found even in greenest,
Sector Policies non-polluting sectors.
ESG heatmaps To ensure that the risks management
ESG heatmaps provide an assessment of system is controlled coherently, new risk Stress Test Methodologies
ESG risks per portfolio in terms of a heat assessment approaches such as climate risk Stress tests analyze how portfolios, and
score. Outside-in, the heatmaps published assessment must include limits and related therefore banks behave under various
by UNEP FI Principles for Sustainable standards concerning the banks’ main risks, hypothetical macroeconomic scenarios
Insurance (2018)14 can provide a starting as well as different risk strategies for each of the future and are formed by a set of
point, while financial actors need to map the sector. For this purpose, an EU taxonomy assigned variables. A typical stress test
information to their portfolios, in the long was published to provide details on activities includes a scenario, accompanied by a

ECONOMIC SECTORS
Finance (depending
Construction/Hydro
Agriculture/Fishing

Agriculture/Paper &

Transport/Shipping
Construction/Oil &
Construction/Coal
Energy Operation

Fuels/Derivatives

Utilities (Waste &

Pharma/Biotech/
on client and/or

Manufacturing

Manufacturing
Food/Beverage
Infrastructure/
Construction/

Production of

from Oil & Gas

Exploration &

Construction
Agriculture/

transaction)
Technology

Healthcare/
Electronics/

Life Science

Real Estate
Gambling
Chemicals
Livestock

Garment
Defense
Forestry

CRITERIA THEME RISK CRITERIA RISK MITIGATION EXAMPLES & GOOD PRACTICE
Nuclear

Mining
Water)
Dams

Gas

Disclosure of climate-related emissions in operations and/or products (e.g. CO2, CH2,

N20, HFCs, PCFs, SF6)
Breakdown of fuel/material/carbon intensity mix relevant to the client or transaction (e.g.
Environment

power generating mix or by economic sector intensity)

Air pollution, greenhouse gas emissions, and transition risks
Climate Environmental & social impact assessment (ESIA) covering negative health impacts, mitiga -
change tion and decommissioning where relevant

Decarbonisation transition plan/targets

-
cal cyclones, sea level rise, water stress) climate resilience adaptation plans)

14 UNEP FI Principles for Sustainable Insurance (2019) Retrieved from https://www.unepfi.org/psi/wp-content/uploads/2019/02/PSI-

Guidance-for-non-life-insurance-underwriting.pdf

11
The Predictive Power of Stress Tests to Tackle Climate Change |
 2. Current risk assessment tools used by banks

covering narrative, a set of models for Following the global financial crisis, securitization risks, sovereign risks, net
evaluating a range of risks under stress, regulatory stress testing exercises have interest income risks, operational & conduct
followed by both a quantitative or qualitative increased, and stress test outcomes became risks and forbearance under baseline,
impact assessment of the outcomes, and more essential as they inform regulators adverse and severely adverse scenarios.
commentary on remediation or strategic on banks’ resilience to a range of stresses
management responses. A stress test and their potential systemic effects. Current
involves a portfolio level assessment (top- stress test exercises are applied over a
down mechanism) reinforced with borrower- period of 3 to 5 years. The scope of the
level calibration (bottom-up mechanism). exercise covers credit risks, market risks,

Compute the
Estimate impacts of
change in
Compute starting values of macroeconomic scenarios on
expected credit
risk parameters point-in-time credit risk
losses and
parameters (PD, LGD, …)
capital

The methodology within the scope of credit risks can be summarized below:

Projected PD per rating Projected LGD Projected EAD Projected NPL

macroeconomic
variables

Impairment / Cost of
RWA
Risk (based on EL)

12
 The Predictive Power of Stress Tests to Tackle Climate Change |
 2. Current risk assessment tools used by banks

Probability of Default (PD): PD describes aggressive strategy in certain loan segments

the likelihood of a default over a particular to take more market share going forward, by forecast by using climate scenarios
time frame. It provides an estimate of the assuring the existence of sufficient capital to which cover up to more than 50
likelihood that a borrower will be unable to withstand extreme stress scenarios. Beyond year-long periods.
meet its debt obligations. strategic decisions, banks can enhance
• Integrating transition risk
performance and internal governance by
assessment in the short term
Loss given default (LGD): LGD is the share incorporating stress test results in other
As the impact of climate risks -
of an asset that is lost in case of default banking activities.
especially transition risks - are
and its projections are based on the bank’s
starting to materialize faster in
recovery rate
shorter periods, a significant
Challenges related to adding a increase in financial risk parameters
Exposure at default (EAD): EAD is the
climate component to existing is expected in the short/
total value to which a bank is exposed at the
stress tests medium term.
time of a loan’s default.

Climate scenarios can be used in a

Non-performing loan (NPL): Non-
similar manner as macroeconomic Existing Internal Capital Adequacy
performing loans or exposures are those
scenarios and estimate the impacts Assessment Processes (ICAAP)
that satisfy either of the following criteria:
of credit risk parameters which can The risk appetite and closely related
(a) material exposures that are more
be used when calculating the change decision-making strategies can be only
than 90 days past due; and (b) the debtor
in P&L. Therefore, stress tests can executed with the existence of a robust risk
is assessed as unlikely to pay its credit
be transformed into a climate stress culture which will ensure banks operate in
obligations in full without realization of
test, however there is still much to accordance with their risk appetite.
collateral, regardless of the existence of any
be done:
past due amount or of the number of days
Banks are not forced to choose a specific
past due. • Integrating portfolio level
risk quantification technique, however
and borrower level analysis
‘it is the responsibility of the institution
Expected loss (EL): The sum of the values mechanisms related to climate
to quantify its risks and to determine
of all possible losses i.e., PD*LGD*EAD scenarios Shifts in risk parameters
projections’ (ECB Guide to ICAAP, 2018). As
need to depend on both the
forward-looking stress tests enable banks
Risk-weighted asset (RWA): Within the portfolio level sector effect and
to forecast their capacity under normal
scope of credit risk, RWA is a measure on different response rates of
and stressed conditions, embedding stress
for capital requirements compliant with counterparties
testing into ICAAP will lead to effective
imposed capital adequacy requirements. It
• Lack of high-quality historical definition, monitoring and reporting of the
affects the amount of capital the bank needs
data Climate stress tests must risk profile. It is fundamental to incorporate
to retain.
capitalize on existing data, but as a stress testing framework in ICAAP to
climate-related historical data is not achieve a clear definition of capital adequacy
A robust stress test exercise can help
sufficient, top-down approaches to form methodologies used to evaluate
banks make better decisions during
must be combined with intensive capital adequacy.
potential downturns and can facilitate
bottom-up mechanisms.
the development of related action plans.
Risk appetite includes the sensitivities of risk
Financial institutions should see stress tests • Extending scenario time frames
type metrics used for scenario analysis and
more than just meeting the requirements Depending on the maturity of
stress testing. Therefore, the integration of
imposed by new mandatory exercises certain portfolios, a methodological
the climate component to traditional stress
and see it as a tool to have an exhaustive transformation is needed to
tests can create a positive feedback loop
understanding of potential risks. For
example, a bank can establish a more
13
The Predictive Power of Stress Tests to Tackle Climate Change |
 2. Current risk assessment tools used by banks

between banks’ high-level strategic plans on evolution of sectors and climate-related decision-making processes, therefore outputs
sustainability, by generating the information financial impacts, and thus maintain a of climate stress tests should be consistently
flow necessary for the continuity of consistent climate strategy. utilized in all risk management related
sustainable portfolio management. activities. Therefore, banks need to evolve
The current practices of banking their existing risk methodologies to introduce
The risk appetite statement will be affected institutions are not adequate for the climate stress test methodology and
by the integration of climate risks, as it is integration of climate modeling. To add related governance.
closely related to risk management practices a climate component to existing banking
and sensitivities. As ICAAP processes activities, existing risk assessment tools need
transform with the climate stress tests, to be transformed. It is not sufficient to apply
banks can forecast the climate related climate quantification in only some of the

14
 The Predictive Power of Stress Tests to Tackle Climate Change |
 3.Building an appropriate climate stress testing framework in the scope of corporate loans

3.Building an appropriate climate

stress testing framework in the
scope of corporate loans
Stress test analysis has the capacity to Step by step approach to climate transition speed is low and therefore
answer questions a bank might have on stress-testing transition risks are significantly elevated
climate-related risk. Therefore, banks can
leverage the macroeconomic and financial Step 1 - Portfolio Analysis A maturity analysis of the portfolio is
stress testing framework and integrate a Understanding the portfolio is a key step in fundamental for choosing the horizon of the
climate component to make climate stress building climate stress tests. As a climate risk climate-related analysis, as a methodological
tests coherent with their assessment requires extensive resources, transformation is required to integrate
existing methodologies. data and analysis, the most vulnerable longer horizons of climate scenarios. The
sectors need to be prioritized. This can be sectors which have longer horizons will
• The ideal climate-related stress test
done via portfolio analysis, which consists of be better suited to applying a climate
methodology should include the following:
reviewing existing portfolio asset allocation risk-related assessment, since the current
• Portfolio Analysis in terms of defined sectors and sub-sectors. portfolio is exposed to climate risks to a
For this purpose, three crucial analyses greater extent.
• Scenario Selection
need to be performed.
• Stress Test Methodology The horizons of the current stress test
– Top-down Mechanism First, sector exposure needs to be checked methodologies are not coherent with the
– Bottom-up Mechanism to detect primary concern sectors. climate risk occurrence horizon. Within
Secondly, more detailed analyses need to be the scope of corporate loans which have
• Calibration
performed. For instance, the geographical relatively shorter maturity, differing horizons
• Impact Assessment distribution of the portfolio needs to be of physical and transition risks should be
assessed to verify: considered in order to interpret the climate
Stress testing offers combined depth and risk impact on banks’ different
• The proportion of assets in zones which
flexibility to incorporate both qualitative and strategic processes:
are more exposed to a substantial
quantitative considerations from a range of
increase in physical risks (i.e., potential
risks, and an aggregate analysis that links
intensity of extreme weather events)
the risks with their financial implications and
a remediation plan (strategic actions). • The geographies where low-carbon

Expected time Banks’ Strategic Processes

horizon at which
Banking Portfolio Market Portfolio Assets & Liabilities
climate risks will
likely materialize Loan-related Risk Appetite Investment-related Risk Appetite Solvency & Compliance
Activities Framework Activities Framework Liquidity

Physical Short-term Long/Medium-term Short-term material Medium-term Medium/Short-term Long/Medium-

Climate-related
Risk Channels

Risk material effects material effects effects material effects material effects term material
effects

Transition Short-term Medium-term Short-term material Medium-term Short-term Medium-term

Risk material effects material effects effects. material effects material effects material effects

Source: Authors

Horizon selection should take into account both the maturity of the portfolio and expected time horizons at which climate risks will
likely materialize.

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The Predictive Power of Stress Tests to Tackle Climate Change |
 3.Building an appropriate climate stress testing framework in the scope of corporate loans

Step 2 - Scenario Selection To perform stress tests, financial institutions For example, reference scenarios should
A forward-looking scenario analysis need to establish downscaled climate be geographically downscaled depending
enhances strategic thinking and provides scenarios. Thus, they need to leverage on the nature of the portfolio. To model
meaningful insights on climate-related risks reference climate scenarios. Temperature- different climate-related modules
and opportunities. To ensure meaningful based scenarios created by research simultaneously, there are climate scenarios
pathways, scenarios need to be chosen institutions are the most advanced type which can simultaneously demonstrate
to be transparent, granular, reliable and of reference scenarios, however as they relations between different domains such as
complex enough to integrate different kinds are not primarily created for financial risk the economy, energy and the climate:15
of parameters and to assess their impacts. assessment, they need to be modified

Scenario Narrative

Demographic Changes, Socio-economic

MODEL 1 Economic Development, drivers
Technological Changes
Policy Assumptions
Climate

Socio-economic
Emissions drivers

MODEL 3
MODEL 6
MODEL 4 MODEL 5
Air pollution
Carbon
emission &
MODEL 2 price
abatement Land Use
costs Energy &
Pollution
Economy
Bioenergy potential
(agriculture, forest),
Land-use emissions, Consistency of
Mitigation potential land-cover changes

Advanced climate scenarios provide a techniques, advanced reference scenarios more fitting with the objectives defined for
climate output which demonstrates the provide a complete set of outputs which the climate-related assessment. Complex
interlinked impact between socioeconomic, are key to model transition risks. The scenarios which consider both mitigation
demographic, macroeconomic and combination of different IAM models and adaptation challenges to shock
technological evolution. Thanks to (which are compatible with global climate portfolios’ resilience can lead the banks to
integrated assessment modeling (IAM) models) can make the scenario’s narrative consider physical and transition risks.

15 Representation adapted from the IIASA IAM Framework

16
 The Predictive Power of Stress Tests to Tackle Climate Change |
 3.Building an appropriate climate stress testing framework in the scope of corporate loans

Reference Climate Scenarios physical risks, and it is a set of climate RCP 2.6, 4.5, 6.0 and 8.5 are the four
The International Panel on Climate Change scenarios based on different levels of GHG main RCPs scenarios arising from the
(IPCC) use the following scenarios: concentration. Each RCP targets a different Intergovernmental Panel on Climate
level of radiative forcing and shows how Change’s (IPCC -GIEC) 2014 fifth
RCPs: Representative Concentration the climate system develops accordingly assessment report (AR5).
Pathways (RCPs) were developed primarily without taking into account socio-
for evaluating parameters related to economic changes.

RCP 2.6 RCP 8.5

Developed by PBL Environmental Developed by International Institute for

Assessment Agency, Netherlands Applied Systems Analysis (IIASA) Austria

RCP 2.6 predicts a future where there is an RCP 8.5 predicts a future without any policy changes
ambitious reduction of GHG emissions which adopted therefore it is equivalent to Business-as-
becomes net negative before 2100, align with the Usual Scenario. As radiative forcing increases the
Paris Agreement. intensity of climate risk increases.

RCP 4.5 RCP 6

Developed by Pacific Northwest National Developed by National Institute for
Laboratory, USA Environmental Studies (NIES) Japan

RCP 4.5 predicts a future where total radiative RCP 6 predicts a future where total radiative
forcing is stabilized shortly after the year 2100, forcing is stabilized shortly after the year 2100,
emissions peak around 2040. emissions peak around 2080 and then decline.

17
The Predictive Power of Stress Tests to Tackle Climate Change |
 3.Building an appropriate climate stress testing framework in the scope of corporate loans

RCP Projections on Radiative Forcing

9.000

8.000

7.000

6.000

5.000

4.000

3.000

2.000

1.000

0.000
2000 2005 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100

RCP 6.0 RCP 4.5 RCP 2.6 RCP 8.5

Each RCP corresponds to a different rate and magnitude of climate change.

SSP: The Integrated Assessment Modeling The scenarios are: level of mitigation and adaptation
Consortium (IAMC), formed by research SSP 1: Sustainability (Taking the Green achieved globally:
institutions worldwide, developed Shared Road), SSP2: Middle of the Road, SSP3:
Socio-economic Pathways (SSP) which will Regional Rivalry (A Rocky Road), SSP4: Projections are made by different
be included in the IPCC’s 6th Assessment Inequality (A Road Divided), SSP 5: Fossil- integrated assessment models and the
Report. The scenarios represent diverse fueled development (Taking the Highway) most representative outputs are named
qualitative descriptions related to the as marker scenarios. Marker scenarios are
achievement of sustainable development The narratives enable the exploration selected by research institutions among
goals (SDGs) and project interrelated and examination of socioeconomic several hundred scenarios.
changes in socio-economic, energy, land- developments related to climate change
use and GHG emission systems until the impacts and the resulting vulnerabilities.
year 2100. Scenarios are designed to address the

18
 The Predictive Power of Stress Tests to Tackle Climate Change |
 3.Building an appropriate climate stress testing framework in the scope of corporate loans

SSP Projections on CO2 Emissions (MtCO2/yr)

140000
SSP 5-Taking the
120000 Highway (4.7-5.1°C)

100000
SSP4-Road divided
(3.5-3.8°C)
80000

SSP3-Rocky road
60000 (3.9-4.6°C)

40000
SSP2-Middle of the
road (3.8-4.2°C)
20000

SSP1-Taking the
0
Green road (3-3.5°C)
2005 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100

SSP1-Baseline SSP2-Baseline
SSP3-Baseline SSP4-Baseline
SSP5-Baseline
Each SSP portrays a different rate and magnitude of climate change.

Each SSP is formed by different sets of qualitative assumptions in terms of the economy, policy reactiveness, technological acceleration,
resource use and shared climate policy assumptions, which is by definition not included in SSP-baseline scenarios (corresponds to the
mapping with RCP 8.5):

19
The Predictive Power of Stress Tests to Tackle Climate Change |
High  3.Building an appropriate climate stress testing framework in the scope of corporate loans

Fossil-Fueled Development (SSP5) Regional Rivalry (SSP3)

! Strongly globalized, increasingly connected ! De-globalizing, regional security
! Materialism, status consumption, tourism, mobility, ! Material-intensive consumption
meat-rich diets
! Low priority for environmental issues
! Focus on local environment with benefits to ! Policy oriented toward security
wellbeing, little concern with global problems ! Weak global institutions/national governments
! Toward development, free markets, human capital dominate societal decision-making
! Increasingly effective, oriented toward fostering
competitive markets ! Slow tech change, directed toward domestic
energy sources
! Directed toward fossil fuels; alternative sources not ! High energy & carbon intensity in regions with large
actively pursued domestic fossil fuel resources
! High carbon intensity
! Unconventional resources for domestic supply
! No constraints on fossil fuel use ! Serious environmental degradation Economy
! Highly engineered approaches to successful & Lifestyle
management of local issues ! Fragmentation up until 2020
! Regions with income > 12600 US$/capita in 2020
Policies &
start linear transition to global carbon price up
Institutions
Challenges to mitigation

! Fragmentation up until 2020

until 2040
! Thereafter, transition to globally uniform carbon
! Others start only 10 years later with transition up
price up until 2040
until 2050
Technology

Sustainability (SSP1) Inequality (SSP4) Environment &

Natural Resources
! Connected markets, regional production ! Globally connected elites
! Low growth in material consumption ! Elites: high consumption lifestyles; Rest: low
consumption, low mobility Not in baselines;
only mitigation
scenarios: Shared
! Improved management of local and global ! Focus on local environment in MICs, HICs; climate Policy
issues, tighter regulation of pollutants little focus on vulnerable areas, global issues Assumptions (SPA)
! Policy oriented toward sustainable development ! Toward the benefit of the political & business elite
! Institutions effective at national and ! Institutions are effective for political & business
international levels elite, not for rest of society

! Tech change directed away from fossil fuels, toward ! Diversified investments including efficiency and
efficiency and renewables low-carbon sources
! Low carbon and energy intensity ! Low/medium carbon and energy intensity

! Anticipation of fossil fuel constraints drives up

! Preferences shift away from fossil fuels prices with high volatility
! Improving environmental conditions over time ! Environment is highly managed and improved near
high/middle-income living areas

! Fragmentation up until 2020 ! Fragmentation up until 2020

! Thereafter, transition to globally uniform carbon ! Transition to globally uniform carbon price
price up until directly thereafter
Low

Low Challenges to adaption High

Adapted from: Bauer et al. 2017

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 The Predictive Power of Stress Tests to Tackle Climate Change |
 3.Building an appropriate climate stress testing framework in the scope of corporate loans

SSP Inputs SSP Narratives

SSP 1, 2, 3, 4, 5 GDP Population Urbanisation

IAM Models

Energy Land RCP/SSP

Mix Use Outputs

Tailored Scenario
Narrative &
RCP Inputs Future Climate
Pathway
IPCC AR5: RCP Concentration & Radiative Forcing
2.6, 4.5, 6, 8.5

SSP scenarios can be mapped to RCP scenarios and used together

Financial institutions should also consider fundamental to take into account multiple helps have a systemized output after
increasing the stress by amplifying the scenarios. Certain medium-sized players performing quantitative projections.
level of disorder of low-carbon transition. prefer to use reference scenarios that Related determinants and the scope
consider the link between social and of influence of demographic, national
The choice of scenarios is extremely regulatory policy actions. and international policy actions, macro-
important for institutions to correctly economic, technology-related and
model plausible pathways. Due to the Handling sector specificities: consumption-related variables need to
complexity of climate modeling, banks Each sector will be affected differently by be considered while forming narratives.
need to rely on existing climate scenarios climate change, and critical climate risk For each identified sector, it is essential to
as reference scenarios. Some drivers should be included to identify form climate narratives which can model
banks will prefer to formulate their the correct climate risk exposure. Sector- the evolution of that sector. Narratives
own forward-looking climate scenarios; related climate impacts need to be need to be set and explicitly cover the
however this requires the development included in sector scenarios. required aspects of climate-change impact
of tremendous in-house capacities to to comprehensively assess risks. To ensure
undertake climate-related analytics. Climate scenarios should be extended the quality of scenarios and narratives, the
Science-based reference scenarios offer to narratives by adding key drivers which financial institution should consult climate
the modeling expertise of leading research will enable them to perform a granular experts, sector experts, risk experts and
institutions. By using similar drivers in climate risk assessment. Creating a economists, which will also facilitate the
scenarios, results can be compared sector narrative enables the scenario validation process
between different sectors and between to be tailored, provides a consistent
banks. Some major banks think it is context regarding input assumptions and

21
The Predictive Power of Stress Tests to Tackle Climate Change |
 3.Building an appropriate climate stress testing framework in the scope of corporate loans

Step 3 - Quantification via Stress most significant counterparties to cover environmental and macroeconomic expert
Test Modeling a material part of the portfolio. According judgment can be used in order to improve
Stress test modeling via financial climate to PRA16 ‘counterparty-level assessment the calibration and the quality of models.
shocks is achieved by two different should aim to cover 80% of participants’ In cases where banks lack internal data
complementary approaches, a top-down ‘nominal exposure’ in the scope of corporate on borrowers such as data on borrowers’
macro analysis, reinforced with a bottom-up loans.’ There are multiple qualitative and key operating assets, their locations etc.,
micro analysis. The aim is to incorporate quantitative ways to map sector and external data sources should be used.
shocks at portfolio and borrower geographic vulnerabilities of counterparties Geographical data becomes fundamental
level to calculate systematic and and to assess their financial impact. The for sectors that are more prone to location-
idiosyncratic risks, which maximizes granularity of the assessment, hence the based climate risks.
the power of the climate identified vulnerabilities of counterparties’
risk assessment. business models, needs to be justified. Data requirements related to climate
risk assessment
The top-down mechanism enables the bank Quantification is performed by deriving the Building such a climate stress test
to perform portfolio level-assessment. financial effect of physical and transition methodology would require a large amount
The methodology needs to be adjusted to risks on credit risk parameters which can of data, gathering both banking portfolio
the different sizes of enterprises present impact the balance sheet of individual data and external data regarding economic
in the corporate portfolio. For example, institutions. The transmission channel of and climatic forecasts.
the level of treatment might differ for climate risks determines the choice of risk
SMEs depending on the data availability KPIs (PD, LGD, EAD etc.) which will shift A combination of internal and external
and quality. The aim of the top-down under different climate scenarios. With data is needed to perform a climate risk
analysis is to describe the evolution of top-down and bottom-up mechanisms, the assessment. Internal data consists of risk
credit quality under different magnitudes risk parameters are altered. To eliminate KPIs and related metrics such as PD, LGD,
of climate change. As scenarios are based overlaps between two mechanisms, the EAD at loan origination. The shift between
on climate-related, macroeconomic and coherence of assumptions, methodology these metrics in a Business as Usual
financial variables related to the sector, the and the output should be inspected. For this scenario and in a climate stress situation
forecast of variables will represent sector reason, calibration is carried out. becomes key to assess the impact of climate
transformation. This can be translated into scenarios on the Expected Loss financial
the impact on risk parameters; therefore Step 4 - Calibration data of the analyzed portfolio. Asset-based
the analysis leads banks to forecast the Calibration is performed to consolidate data and maturity-related data is also
portfolio’s credit quality related to the top-down and the bottom-up parts necessary to build the
climate risks. of the assessment. It is crucial to ensure methodology accordingly.
consistency between different mechanisms
The bottom-up mechanism allows the and various methodologies used for
banks to ascertain the vulnerabilities at different sizes of actors. The aim is to
counterparty level, so a lot of external data maximize the operationality of each model.
needs to be collected. It is an accurate To facilitate calibration, banks’ existing
process which adds tailored sensitivity to metrics can be used. Leveraging existing
the analysis. As actors in the portfolio have parameters and data will augment the
differentiated responses to climate change operationality of the climate stress test and
at different rates of transition, bottom-up increase its applicability. Internal bank data
analysis results in the incorporation of can shape sector drivers which are essential
actors’ varying sensibilities. It is important to extensively cover the evolution of a sector
to apply the bottom-up approach to the in different climate scenarios. Specifically,

16 PRA (2019) Discussion Paper: 2021 Biennial exploratory scenario on the financial risks from climate change

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 The Predictive Power of Stress Tests to Tackle Climate Change |
 3.Building an appropriate climate stress testing framework in the scope of corporate loans

External data is grouped into three different types:

Macroeconomic data
Climate-related data
(global output evolution Sectoral data (external
(emissions, temperature
by sectors, inflation, ratings per sector, losses
increase carbon mix,
unemployment, population incurred, … )
policy related data, …)
growth,…)

Financial data (external ratings per sector, evolution of credit ratings, … )

Different types of data are needed to External data quality of historical data cannot represent
explain the shift created by climate-related the non-linear impacts of climate, external
• Evolution of credit ratings
parameters on financial parameters. datasets based on present-condition
– S&P
information offer a more profound
– Moody’s
Internal data benchmark to interpret results.
• Performance indicators of exposures
• Carbon-related data (e.g., carbon intensity
and assets
exposure/assets/portfolio)
– MSCI, …
• Share of income exposed to sectors
• ESG ratings
• General information about the borrower,
loan details, financial data of the In terms of external data, open-source data
analyzed portfolio is increasing and getting more robust and
reliable with the help of scientific actors.
• Risk KPIs at loan origination
Banks should leverage the existing data
(PD, LGD, EAD, …)
rather than using resources to obtain or
• Duration of exposures create new databases. Moreover, as the

23
The Predictive Power of Stress Tests to Tackle Climate Change |
 3.Building an appropriate climate stress testing framework in the scope of corporate loans

Use-Case in the Automotive Sector

Deloitte has worked with a major French bank to incorporate a climate stress testing framework in the scope of corporate loans to study
transition-related risks and opportunities:

Portfolio After performing a portfolio analysis, the automotive sector was identified as one of the sectors
Analysis which are prone to climate risks. The time horizon was chosen to be 2030.

SSP 1/RCP 8.5 (baseline of sustainable scenario), SSP 3/RCP 8.5 (baseline of slow development
Scenario
scenario) SSP 5/RCP 8.5 (baseline of fossil-fueled development scenario) were chosen. Sectoral
Selection
parameters were added which directly affect the sale and production of automobiles.

Stress Test
A statistical model was produced to determine a relationship between key sectoral macro and
Modeling/
financial variables and climate-related variables. For the top-down approach, statistical
Calibration
downscaling was applied. Environmental data was extracted on significant actors for the
bottom-up approach.
A material impact was observed on PD therefore in ECL and RWA and the solvency ratio. In
2030, a significant increase was observed in RWA and ECL nearly doubled under SSP 3
Assessing Impact
scenario.

Cumulative PD for low risk rating under SSP scenarios

0.60%

0.50%
0.40%

0.30%
0.20%
0.10%
0.00%
1 2 3 4 5 6 7 8 9 10

SSP1 SSP2 SSP3 SSP4 SSP5

The bank decided to increase the provisions of the automotive sector due to the results of the climate stress test.

24
 The Predictive Power of Stress Tests to Tackle Climate Change |
 4.Enhancing climate-related governance

4.Enhancing climate-
related governance

Climate risk assessment involves the active in order to reflect climate risks in different Executive incentives should be based on
engagement of multiple departments. banking activities and raise awareness. methodology outputs and should aim to
Financial institutions need to reorganize Financial institutions need to ensure the promote a long-term climate plan of action.
their governance to ensure that all diverse composition in knowledge and
aspects of climate risks are owned, skills to determine the most effective way The success of implementation depends on
monitored, measured and communicated. to integrate climate considerations and effective communication, which will lead to
Risk management and corporate social perform opportunity assessments with the creation of multi-functional teams and
responsibility teams need to work together the help of identified material climate risks. new synergies:

Senior
Management

• Sector Experts
• Economists
• Other stakeholders

Climate risk
assessment

Risk Teams Sustainability Teams

Lead the assessment Lead the assessment with
with modelling expertise climate-related expertise

25
The Predictive Power of Stress Tests to Tackle Climate Change |
 4.Enhancing climate-related governance

Climate
Risk Strategy

Risk organization
& governance

Risk execution

Risk mitigation & monitoring

Risk measurement & tools

The climate risk assessment should be coordinated and reported to the board to turn climate risk quantification into climate intelligence, and
to integrate climate strategies across the firm. When CSR and risk teams collaborate and share responsibilities on climate risk assessment,
new KPIs related to sustainable development can be defined and the continuity of the climate risk assessment will result in
modified governance.

26
 The Predictive Power of Stress Tests to Tackle Climate Change |
 How can Deloitte help?

How can Deloitte help?

ClimWISE, a leading solution to build evaluates sectoral and geographical • A modular bottom-up approach,
resilience to climate change sensitivity with a global heatmap and can counterparty sensitivity analysis
Deloitte has developed ClimWISE, a dynamic perform specific climate stress-tests based
• Quantification of climate-related risks
decision-making tool for management on science-based scenarios and models.
by leveraging the traditional stress test
which helps financial stakeholders manage The tool assesses transition risk under
methodology
their portfolios. It is an end-to-end the constraints of different climate risk
solution adaptable to banks’ existing risk scenarios and leverages the portfolio by With ClimWISE, do not get lost in transition,
management methodologies. identifying and reporting transition climate lead it!
risk exposures.
ClimWISE assesses the ability to Annex: Implementation of the TCFD
• Robust identification of the concentration
integrate into a low carbon transition by recommendations – holistic project
of transition risk on portfolios of financial
identifying the transformation capacity of approach
activities
counterparties’ business models. Moreover, Implementing the TCFD recommendations
Deloitte’s tool facilitates concentrating • Sectoral and geographical downscaling of will most likely become a core requirement
quantification efforts on risk areas and climate scenario-related inflection points of regulatory compliance regarding climate
seizing opportunities. risk management in the near future.
• Use of the most up-to-date, reliable
Therefore, sketching the project roadmap
external datasets to quantify the impact of
ClimWISE evaluates the capacity of is a challenge for today. At Deloitte, we
various transitional risk indicators
business models to integrate into build a holistic project approach leveraging
a low carbon transition by a high- • Outside-in, Merton-like top-down the knowledge of a major international
performance tool. approach to estimate losses and identify consultancy firm and bringing together our
Being an approach that responds to climate-related opportunities tools and enablers such as ClimWISE.
expected regulatory changes, ClimWISE

TCFD Recommendations Project Activities

Governance a) Describe the board’s oversight of 1) Identify climate risks in the organizations’ portfolios, and assess
climate-related risks and opportunities. the organizations’ capacity to identify, measure and manage them:
Disclose the organization’s
governance around b) Describe management’s role in • Develop a specific climate risk heatmap for the organization
climate-related risks and assessing and managing them.
• Leverage outside sources such as PSI heatmaps, EU taxonomy,
opportunities.
PRI risk indicators, etc.
Strategy a) Describe the climate-related risks
2) Identify climate-related opportunities, and assess the
and opportunities the organization has
Disclose the actual and organizations’ capability to exploit them
identified over the short, medium, and
potential impacts of
long term. 3) Establish overall responsibility of board and senior management
climate-related risks and
regarding climate risks – from vision to implementation plan:
opportunities on the b) Describe the impact of climate-
organization’s businesses, related risks and opportunities on the • Risk strategy and risk appetite
strategy, and financial organization’s businesses, strategy,
• Roles and responsibilities
planning where such financial planning.
information is material. • Policies and processes
c) Describe the resilience of the
organization’s strategy, taking into • Management reports
consideration different climate-related
4) Set up organization-wide strategic approach –
scenarios, including a 2°C or lower
implementation plan:
scenario.

27
The Predictive Power of Stress Tests to Tackle Climate Change |
 How can Deloitte help?

TCFD Recommendations Project Activities

Risk Management a) Describe the organization’s processes • Understand impact of climate change on the organizations’
for identifying and assessing climate- risk profile
Disclose how the
related risks.
organization identifies, • Identify need to adapt strategy and governance
assesses, and manages b) Describe the organization’s processes
• Set clear targets, planning and budget
climate-related risks. for managing climate-related risks.
• Assign responsibilities and reporting lines for the project
c) Describe how processes for climate-
related risks are integrated into the • Ultimately, implement amendments to policies and processes
organization’s overall risk management..
5) Establish risk management cycle
Metrics and Targets a) Disclose the metrics used by
5.1) Risk identification
Disclose the metrics and the organization to assess climate-
• Use heatmaps (see activity 1) to identify climate risk
targets used to assess related risks and opportunities in line
concentrations (esp. energy-intensive industries, mortgage
and manage relevant with its strategy and risk
collateral and project financing)
climate-related risks and management process.
opportunities where such • Perform scenario-based sensitivity analyses (esp. risk/shock
b) Disclose Scope 1, Scope 2,
information is material. types, sectors and time horizons)
and, if appropriate, Scope 3 GHG
5.2) Risk assessment
emissions, and the related risks.
• Perform dedicated climate risk stress tests for loan portfolios (e.g.,
c) Describe the targets used by the
in the context of ICAAP) using ClimWISE methodology:
organization to manage climate-
related risks and opportunities and (a) Input: Socioeconomic pathway based on integrated
performance against targets. assessment models

(b) Bottom-up analysis: Impact on selected individual companies

(c) Top-down analysis: Impact on loan portfolio

(d) Output: Scenario PDs and LGDs per obligor

• Perform dedicated climate risk performance analysis for

investment portfolios using Deloitte’s methodology based on big
data and advanced analytics:

(a) Cluster companies that disclose carbon/GHG indicators, and

classify non-disclosing companies accordingly

(b) Calculate asset value sensitivities (betas) w.r.t. carbon/

GHG indicators

5.3) Risk avoidance/mitigation & risk monitoring

• Amend risk appetite statement with dedicated climate risk limits

• Amend credit and collateral policies with dedicated climate

risk rules

28
 The Predictive Power of Stress Tests to Tackle Climate Change |
 How can Deloitte help?

TCFD Recommendations Project Activities

• Amend client and transaction acceptance with dedicated climate

risk rules

• Encourage clients to transfer risk (e.g., by taking out climate

risk insurance)

• Mitigate impact of physical climate risks on the

organization’s operations

6) Set up climate risk disclosure report

• Carbon footprinting

• Green/brown exposure

• Company engagement

• Ratings and research

• Scenario analysis

• Impact metrics

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The Predictive Power of Stress Tests to Tackle Climate Change |
 How can Deloitte help?

Contacts

Hervé Phaure Olivier Jan

Risk Advisory Credit Risk Partner Deloitte France and Deloitte
01 55 61 23 01 Global Sustainability Leader
hphaure@deloitte.fr 01 55 61 60 81
ojan@deloitte.fr

Eric Dugelay Nicolas de Jenlis

Risk Advisory Sustainability Risk Advisory Sustainability
Services Partner Services Director
01 55 61 54 13 01 40 88 70 91
edugelay@deloitte.fr ndejenlis@deloitte.fr

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The Predictive Power of Stress Tests to Tackle Climate Change |
 How can Deloitte help?

31
About Deloitte
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private
company limited by guarantee (“DTTL”), its network of member firms, and their
related entities. DTTL and each of its member firms are legally separate and
independent entities. DTTL (also referred to as “Deloitte Global”) does not provide
services to clients. In the United States, Deloitte refers to one or more of the US
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