Tools used by financial regulators to gauge the impact of climate change on the financial system are probably underestimating the potential damage because of incomplete data and inadequate scenario analyses, according to Financial Stability Board, a watchdog group.
With extraordinary fires, floods and tornadoes on the rise, national authorities are increasingly conducting so-called climate scenario analysis exercises, testing how their financial systems might be hit by such events. But the field is a new one and the data is incomplete, according to a report jointly published by the Basel-based FSB and the Network for Greening the Financial System, a group of central banks and supervisors.
Scenarios developed by NGFS are used by national authorities, though their application isn't identical because countries conduct stress tests differently.
"Climate scenario analysis is becoming an increasingly important tool for central banks and regulators to identify and assess climate risks in their economies and financial systems," Ravi Menon, chair of the network, said in a statement. "The significance of these risks has been driven home by the global energy crisis unleashed by the war in Ukraine and the recent spate of extreme weather events."
The initial results of these climate stress tests are incomplete, however, the report found. At first read, the exercises suggest that climate risks, "though not small," are nevertheless concentrated in some industries and can be contained, so they don't spread to the financial system. What the exercises generally fail to catch though are the ripple effects, for example if markets plunge as the worst-hit industries sell off assets at heavily discounted prices, the report said.
Previous research has indicated that stranded assets may reach $20 trillion in just the energy and utilities sectors, which face the largest climate-transition challenges.
More work globally needs to be done to collect and analyze data, improve the scenarios used and develop methods of calculating potential impacts, the organizations said.
"A key priority going forward will be to enhance the understanding of how first-round and second-round effects under different scenarios could give rise to financial stability concerns," Klaas Knot, chair of the FSB, said in the statement.
