Climate stress testing

The transformation of capital allocation

Author: Huw van Steenis, Chair, Sustainable Finance Committee, UBS Group

2021 will likely be the year when investors and financiers mainstream climate transition analysis in their loan books and portfolios. Eighteen central banks will run climate transition stress tests in 2021. Over time, the tests could be highly catalytic in repricing the cost of capital between high and low carbon companies. Investors will want to get ahead of this trend.

Climate transition analysis and stress testing of loan books and investor portfolios is about to go mainstream. Two years ago the Bank of England announced it would be the first central bank to run exploratory climate transition stress tests based on recommendations by the Taskforce for Climate Related Financial Disclosures (the TCFD) across the entire financial system, catalyzed by the Future of Finance report. In 2021, 18 central banks including those of Japan, Australia and Singapore, as well as the ECB will be stress testing their financial systems for climate transition.

To create a solid foundation for this process, the Central Banks and Supervisors Network for Greening the Financial System (the NGFS) worked with climate scientists and investors to devise three probable climate policy scenarios, which were published in June 2020. The idea is to determine whether firms are “transition ready” for a lower carbon economy.

The insights these tools and tests produce are likely to be used by boards and investors to change practices in asset allocation and risk management. Tests designed by Australian policymakers will, in fact, explicitly also cover pension funds, not just banks and insurers.

Climate risk moving to the center of attention for central banks and supervisory authorities

Oil price collapse in early 2020 resetting the paradigm

Even before the pandemic, climate transition was rising up the pecking order, but the pandemic has pushed it far higher. 2020 saw the biggest shock to the oil and gas market in 70 years. By the end of December 2020, traditional oil and gas shares in the S&P 500 were down 38% year on year. In the same period global clean energy stocks rose by 140%, which was more than the growth in the tech sector.

The sharp fall in energy prices raised the specter of worthless “stranded assets” and project cancellations. For some, these had been theoretical constructs decades away. However, as lenders and bond investors saw the potentially catastrophic loss in value, financiers are now beginning to reappraise their portfolios. The pandemic is also bringing home the potential of exogenous ecological shocks to have major impacts on asset prices. This means all investors are having to reset their paradigms for investing and lending to energy firms – and, as they reset, including in their paradigms new expectations about energy transition.

Measuring and assessing long-term trends and the interactions between climate science, public policy, economics, and financial markets is a complex undertaking. In a world of interconnected global supply chains and intersecting legal, regulatory, and operating environments, it is not easy for market participants to make sense of the potential impact of climate change and the strategic responses to it.

Information basis for stress tests still not good enough despite lots of progress having been made

Until now, investors, lenders and insurers have lacked a clear view of how companies may fare as the environment changes, regulations evolve, new technologies emerge and customer behavior shifts. Without high-quality, comparable data, financial markets struggle to price climate related risks and opportunities effectively.

We have seen great strides in disclosures. What’s more, ratings agencies and index companies are adding on climate tools as business as usual. Many have bought boutiques in the last 12 months. This will also help to embed climate transition tools.

Most central banks have said the first exercises are exploratory and won’t impact banks' apital buffers. But should they prove effective, it is plausible they will feed into prudential requirements for banks and insurers probably within five years. This could have a material impact on the cost of capital of lending to highly polluting firms.

There are, of course, plenty of caveats. The models are still in their early phases. A priority for policymakers and investors will be to separate signals from noise. Central bankers may take baby steps with the first stress tests as they learn on the job. Another risk is if different policymakers create a cacophony of differing standards, data taxonomies and scenarios – let alone different environmental policies – that will be tough for investors to interpret. There is plenty of data still to gather.

A surprise for 2021? The Fed has applied to join the Network for Greening the Financial System. The base case is that they will watch how the 18 tests will go, but one cannot rule out the Fed considering something along these lines in 2022 or 2023.

The bottom line is this: investors and financial institutions want and need to get smarter in managing climate related risks and opportunities.