Assessing forward-looking climate risks in investors’ portfolios: from theory to practice

Climate-related financial risk is characterised by endogeneity and deep uncertainty. The inadequacy of standard financial risk approaches to deal with these dimensions is a challenge for a smooth transition to a low-carbon economy. Across the last five years, we have developed a stream of work addressing this issue using a framework for climate financial risk management under uncertainty. This framework has been applied to the analysis of climate risk of financial portfolios, in collaboration with financial supervisors.

With this project, we aim to mainstream such a framework in microprudential and macroprudential policies implemented by financial supervisors and financial institutions belonging to the NGFS. We have engaged with relevant NGFS stakeholders through bilateral meetings, focus groups, and international conferences to co-develop narratives related to two main questions:

• How can the available scientific knowledge on climate change mitigation be best applied to identify relevant scenarios of disorderly low-carbon transition?
• What are the implications of scenario selection for investor decisions and for financial stability?

We found there is great importance to foster central banks’ and financial regulators’ understanding about:

• Climate change mitigation scenarios (e.g., those co-developed and used by the NGFS), their limits and opportunities, and the conditions to use them to inform climate stress tests exercises;
• The endogeneity of climate-related financial risks in climate stress test; and
• The conditions for finance to be a driver or a barrier to the transition.