TRISK - A Climate Stress Test for Transition Risk

Abstract:

Climate change has the potential to impact the stability of the financial system. We develop a climate stress test that translates climate transition risks affecting individual firms and economies to shocks affecting the financial system. As part of this, we present a forward-looking risk measure - TRISK - which is the expected loss of a financial institution given the uncertain materialisation of a transition stress scenario. The approach is rooted in asset-level data and represents transition impacts on the level of the firm in a microeconomic and financial model. Key distinct features of the climate stress test are its forward-looking nature based on the transition strategy of firms, the explicit representation of technological costs and firms’ comparative advantage, the transparency and flexibility to accommodate for a wide range of scenarios and underlying modelling choices, and the ability to demonstrate sensitivities in all modelling stages. We perform an exploratory analysis to a selection of international power firms. We find that transition impacts entail significant heterogeneity across firms and the financial sector with clear distributional consequences. This highlights the need for bottom-up stress tests able to reflect the complexity of the transition to inform governments, financial markets as well as financial policy design.