Climate Risk & Stress Testing

Climate change is now recognized as a financial risk for banks. Banks need to manage it just as they manage credit or market risks. Climate stress testing is a tool to understand worst-case impacts and prepare for them.

Types of Climate Related Financial Risks

Climate-related financial risks are broadly classified into physical risks and transition risks.

Physical Risks

These arise from the direct physical effects of climate change. They include acute events such as cyclones, floods, wildfires, and heatwaves that cause sudden damage, and chronic changes such as rising sea levels, altered rainfall patterns, and prolonged droughts. Banks may face direct losses if their own assets (branches, data centers) are damaged.

More importantly, physical risks affect borrowers and collateral. Disasters can lead to loan defaults by farmers, households, and small businesses; insured losses can impact insurer clients; and real estate collateral may lose value. Chronic risks can reduce agricultural incomes, weaken rural loan portfolios, and threaten coastal industries, increasing credit risk, operational risk, and market risk for banks.

Transition Risks

These arise from the shift toward a low-carbon economy. Transition risks include policy and regulatory changes (carbon taxes, emission limits, activity bans), technological changes (renewables replacing fossil fuels, electric vehicles replacing diesel), and market shifts in consumer preferences toward green products.

Banks exposed to carbon-intensive or outdated sectors face higher risk. For example, loans to coal power plants or oil companies may turn non-performing if carbon pricing is imposed or clean energy becomes cheaper. Policy bans (e.g., ending diesel vehicle sales) can affect auto and SME loans. Transition risks also include legal risk from climate-related lawsuits and reputational risk if banks finance polluting activities. Assets like coal mines may become stranded assets, losing value.

Implications for Banks and Financial Stability

If unmitigated, climate risks can increase loan defaults (e.g., regional defaults after floods or industry-wide stress during transition). Collateral values may fall, especially real estate in high-risk or uninsurable zones. Banks’ investment portfolios face market risk if climate events or policies affect interest rates or corporate earnings. At a system-wide level, widespread bank exposure can create systemic risk, such as simultaneous losses from extreme events or sharp declines in fossil fuel assets. Hence, central banks, regulators, and the Financial Stability Board recognize climate change as a major threat to financial stability.

Climate Risk Management by Banks

Banks are increasingly integrating climate risk into standard risk management practices.

• Governance & Strategy: Banks assign climate risk oversight to boards and senior management through Risk or ESG committees. Climate risk is included in risk appetite statements. Many banks align strategies with Paris Agreement goals, commit to net-zero portfolios by 2050, and adjust business models by expanding green finance and reducing high-carbon exposure.
• Risk Identification & Assessment: Banks map portfolios to identify exposure to physical and transition risks (e.g., coastal regions, carbon-intensive sectors like coal, oil & gas, cement). Tools such as heat maps and climate scenarios (e.g., 2°C vs 4°C warming) are used. In India, about 25–35% of bank lending is to carbon-intensive sectors, now tracked as a key metric.
• Data Collection (Financed Emissions): Banks measure financed emissions (Scope 3 emissions of clients) to assess transition risk. Standards like PCAF are used for consistency. Many Indian banks, including private and public sector banks, have begun auditing portfolio emissions to set targets and conduct scenario analysis.
• Integrating into Credit Process: Climate risk is included in credit appraisal through Environmental and Social Risk Assessments (ESRA). High-risk borrowers may face higher pricing, additional conditions, or exclusion. Credit models are being refined to include climate indicators such as carbon intensity and exposure to extreme weather.
• Client Engagement & Transition Plans: Banks engage with clients to support transition through cleaner technologies, advisory services, and portfolio alignment criteria. Continued financing may depend on clients improving sustainability, reducing future default risk.
• Setting Targets and Limits: Banks set quantitative targets (e.g., reducing coal exposure, increasing green finance) and portfolio limits to manage concentration in high climate-risk sectors.
• Insurance and Hedging: Some banks use insurance or derivatives (e.g., for cyclone-prone collateral), though these tools are still limited and mainly applied to banks’ own infrastructure risks.

Climate Stress Testing – Concept and Purpose

Stress testing assesses how a bank’s portfolio performs under severe but plausible scenarios. Traditionally used for recessions or market shocks, it now extends to climate scenarios.
In a climate stress test, banks estimate the impact of extreme climate events on financial performance. Two main scenario types are used:

• Physical risk scenarios: Examples include a once-in-100-year flood hitting multiple economic centers or prolonged droughts. Banks estimate loan defaults, collateral value declines, and capital impacts.
• Transition risk scenarios: Examples include a sudden global carbon tax or rapid replacement of fossil fuels by renewables and EVs. Banks assess effects on borrowers (e.g., coal, oil, refineries) and quantify credit and market losses over long horizons (10–30 years, longer than traditional tests).

The purpose is to assess resilience to climate shocks and identify vulnerabilities early. Regulators may require higher capital, reduced exposures, or better controls. For banks, results guide strategy—such as reducing exposure to high-risk sectors or preparing contingency plans.

Global Developments in Climate Stress Testing

Climate stress testing is evolving, with regulators running pilot exercises:

• Bank of England: In 2021, it conducted the Climate Biennial Exploratory Scenario (CBES) for major banks and insurers, using 30-year scenarios. Results showed significant potential losses under adverse pathways, especially for fossil fuel–heavy models, prompting stronger supervisory expectations.
• European Central Bank: In 2022, it ran a climate stress test combining surveys and quantitative analysis. Findings showed higher default risks from extreme weather and limited climate integration in models, pushing banks to embed climate scenarios regularly.
• Network for Greening the Financial System (NGFS): Provides standardized climate scenarios (orderly, delayed, disorderly transitions) covering temperature, carbon prices, and sectoral outputs. These are widely used by banks and regulators for consistency.
• Other countries: Regulators in France, the Netherlands, Australia, Canada, Singapore, Japan, Malaysia, and Hong Kong have conducted pilots. The Federal Reserve launched a climate scenario analysis for large banks in 2023.

Overall, Supervisors increasingly expect banks to evaluate, integrate, and disclose climate-related vulnerabilities.

India and Climate Stress Testing

In India, the Reserve Bank of India (RBI) is moving toward formal climate stress testing. Its 2022 discussion paper signaled possible regulatory stress tests. A pilot climate stress test was included in the Report on Currency and Finance 2022–23, focusing on transition risk, such as rising carbon prices and their impact on carbon-intensive sectors’ stock prices and creditworthiness. Results showed potential risks to banks’ balance sheets.
By mid-2025, RBI is close to finalizing guidelines requiring banks to conduct periodic climate stress tests. Initially, banks may undertake voluntary scenario analysis from FY 2025–26, followed by supervisory stress tests. Scenarios are expected to include India-specific physical risks (monsoon failure, multi-state floods) and transition risks (rapid renewable adoption, global carbon taxes affecting exports).
RBI has also shared a detailed draft guidance note with large banks on methodologies for climate stress testing. This covers physical risk modeling (using district-level climate vulnerability data) and transition risk modeling (e.g., impact of coal taxes on power producers and loan quality). Timelines suggest voluntary disclosures by FY27 and mandatory disclosures by FY28.

Integration into Capital Frameworks

Regulators are considering linking climate risk to capital requirements under Basel Framework. In October 2025, RBI proposed draft guidelines allowing banks to apply higher risk weights to loans with elevated climate risk.
For example, loans to highly climate-vulnerable firms (such as undiversified thermal power companies) could attract more capital than indicated by credit ratings alone. This would directly link climate risk to loan pricing and capital allocation, integrating it into core banking decisions.

Challenges in Climate Stress Testing

Climate stress testing is complex due to its long-term horizon and lack of historical precedents. Banks face data gaps on borrower-level climate exposure and emissions. Models must translate climate science into financial impacts, requiring interdisciplinary expertise. High uncertainty around policy timing and climate pathways means results are scenario-based projections, not forecasts. Despite limitations, stress tests help identify extreme risks early.

Regulatory Expectations and Way Forward

Regulators, including the Reserve Bank of India (RBI), increasingly expect banks to strengthen internal capabilities for climate risk assessment by developing skills, data, and models; disclose climate-related information, with some banks aligning to the Task Force on Climate-related Financial Disclosures (TCFD); integrate climate risk into the ICAAP under Basel Framework to assess additional capital needs; participate in system-wide surveys and pilot climate stress tests led by RBI; and align lending practices with national climate objectives, including India’s net-zero 2070 target and interim goals such as increased renewable energy financing and reduced exposure to unabated coal.