“Develop methods that map all relevant risks and feedback loops”
What is the focus of the paper?
Financial institutions such as pension funds and insurance companies are increasingly aware that climate change poses significant financial risks. Climate risk stress tests are used to assess the impact of climate risks on financial institutions and on financial stability. Since climate risks differ from traditional sources of risk, these stress tests require new approaches. This paper provides an overview and classification of climate risk stress tests and their limitations.
What are the key findings?
The authors identify important limitations in current climate risk stress tests:
- Neglect of certain types of climate shocks (e.g., ‘Green Swan’ and ‘Minsky’ types).
- Overreliance on macro models.
- Failure to model feedback effects.
- Limited scope of models.
According to the researchers, these limitations may lead to a significant underestimation of potential (system-wide) financial losses as a result of climate risks.
What are the implications?
The authors have several suggestions for further developments in climate risk stress tests:
- Develop methods that map all relevant risks and feedback loops to provide a more complete picture of system-wide losses.
- Develop microeconomic (sector- and region-based) approaches for more accurate risk assessments.
- Develop climate risk stress tests focusing on disasters also for other financial institutions, not just insurers.