Climate scenario analysis and stress testing

Climate-related risks are one of the sources of risk in the financial industry, and in order to maintain the safety and soundness of the financial system and further properly manage climate-related risks, the Hong Kong Monetary Authority issued a circular entitled "Various ways to manage climate-related risks" in July 2020. In December 2020, some local banks were invited to participate in the pilot scheme of climate risk stress testing. As the impact of climate change on financial institutions becomes more apparent, regulators around the world are beginning to require financial institutions to conduct climate risk stress tests, and it is likely that more and more regulators will participate. Forward-looking scenario analysis and stress testing will become an indispensable assessment tool for the financial industry to help financial institutions calmly address climate change.

Background and Necessity:

Global financial regulators are taking action to better identify climate-related risks, estimate potential losses due to climate factors, and manage climate-related risks and their impact on financial stability. Financial regulators in a number of countries and regions have successively issued guidance and/or conducted relevant tests on scenario analysis and climate stress testing.

Climate-related risks are forward-looking, highly uncertain and long-spanned, and cannot rely too much on historical data and experience for statistical and trend analysis, so forward-looking scenario analysis and stress testing are particularly important in climate-related risk assessment and management. Both TCFD and NGFS explicitly propose the use of scenario analysis and/or stress testing tools to assess climate-related risk.

Service Content:

Scenario analysis evaluates a range of hypothetical outcomes by considering various possible future states (scenarios) given a set of assumptions and constraints. Scenario analysis can be qualitative or quantitative combined with data and models. Quantitative analysis is increasingly being used by institutions, and it is common practice for financial institutions to apply climate-related scenario analysis to stress testing.

  1. Determine the pressure object, scope and risk factors of climate stress testing
  2. Set climate pressure scenarios and pressure indicators
  3. Build climate-related risk transmission models and assessment models
  4. Select representative asset samples for multi-dimensional analysis
  5. Collect basic data for climate stress testing
  6. Assess the financial impact under different scenarios

Effects and Significance:

  1. Assist financial institutions in estimating the losses that may result from climate-related risks
  2. Assist financial institutions in improving early warning mechanisms for climate-related risks
  3. Assist financial institutions in establishing responses to climate-related risks

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