Climate Risk Stress Tests

Climate risk stress tests are analytical tools used to assess how climate-related risks may affect the stability, resilience, and performance of financial institutions and the wider economy. In the context of banking and finance, these tests evaluate the potential impact of physical risks arising from climate change, such as extreme weather events, and transition risks associated with policy, technological, and market shifts towards a low-carbon economy. For India, a climate-vulnerable developing economy with a rapidly expanding financial system, climate risk stress testing has emerged as a critical instrument for safeguarding financial stability and supporting sustainable growth.

Background and Conceptual Framework

Climate-related financial risks are generally categorised into physical risks and transition risks. Physical risks stem from acute events such as floods, cyclones, heatwaves, and droughts, as well as chronic changes including rising temperatures and sea levels. Transition risks arise from policy changes, carbon pricing, regulatory reforms, technological innovation, and evolving consumer preferences linked to climate mitigation and adaptation efforts.
Climate risk stress tests extend traditional financial stress testing frameworks by incorporating long-term, uncertain, and non-linear climate variables. Unlike conventional macroeconomic stress tests, which focus on short- to medium-term economic shocks, climate stress tests often operate over multi-decade horizons and require scenario-based analysis. These scenarios are commonly aligned with pathways developed by international bodies such as the Network for Greening the Financial System, which provides reference climate scenarios used by central banks and supervisors globally.

Climate Risk Stress Testing in Banking and Finance

In the banking sector, climate risk stress tests are used to evaluate the impact of climate-related shocks on asset quality, capital adequacy, profitability, and liquidity. Banks assess how exposures to climate-sensitive sectors—such as agriculture, power generation, infrastructure, real estate, and heavy industry—may be affected under different climate scenarios. For example, increased frequency of floods can impair collateral values and disrupt borrower cash flows, leading to higher non-performing assets.
Financial institutions also face indirect risks through interconnected supply chains and macroeconomic feedback loops. Climate stress testing therefore integrates sectoral shocks with broader economic variables such as GDP growth, inflation, interest rates, and employment. The results help banks identify concentration risks, reassess credit allocation, and strengthen risk management frameworks.
From a supervisory perspective, climate stress tests support prudential oversight by enabling regulators to gauge systemic vulnerabilities and encourage forward-looking capital planning. They also promote improved climate risk disclosures and integration of environmental considerations into governance and strategy.

Relevance to the Indian Economy

India is among the countries most exposed to climate change due to its geographic diversity, population density, and dependence on climate-sensitive sectors. Agriculture employs a significant proportion of the workforce and remains heavily reliant on monsoon patterns, while coastal regions face rising risks from cyclones and sea-level rise. These structural characteristics make climate risk stress testing particularly relevant for the Indian financial system.
The Indian economy’s growth trajectory is closely linked to infrastructure development, energy demand, and urbanisation, all of which intersect with climate transition risks. A shift away from fossil fuels, in line with India’s commitments under the Paris Agreement, may affect carbon-intensive industries and the banks that finance them. Climate stress tests help evaluate how such transitions could influence credit risk, investment flows, and overall financial stability.

Role of the Reserve Bank of India and Financial Regulators

The Reserve Bank of India has increasingly recognised climate-related risks as a source of financial instability. In recent years, the RBI has initiated efforts to integrate climate risk considerations into its regulatory and supervisory framework. These include exploratory climate stress testing exercises, guidance on sustainable finance, and expectations for banks to improve climate risk governance and disclosures.
Indian regulators have also encouraged alignment with global best practices while adapting methodologies to domestic conditions. Data limitations, especially at the granular level required for climate modelling, remain a key challenge. Nevertheless, pilot stress tests conducted on select banks and sectors have provided valuable insights into exposure patterns and vulnerability hotspots within the Indian financial system.

Methodologies and Scenarios Used in India

Climate risk stress testing in India typically employs scenario analysis rather than probability-based forecasts. Scenarios may include:

• Orderly transition scenarios, where gradual policy action and technological change lead to moderate economic adjustment.
• Disorderly transition scenarios, characterised by delayed or abrupt policy measures causing significant financial stress.
• Physical risk–dominated scenarios, involving severe climate events with limited mitigation efforts.

These scenarios are mapped onto sectoral balance sheets and loan portfolios to estimate impacts on credit losses and capital buffers. Given India’s developmental priorities, stress tests also consider trade-offs between climate action and economic growth, particularly in energy, manufacturing, and infrastructure sectors.

Implications for Banks and Financial Institutions

For Indian banks, climate risk stress testing has important strategic implications. It encourages diversification away from highly climate-exposed assets and supports the integration of environmental risk assessments into credit appraisal processes. Banks are increasingly required to develop internal capabilities in climate data analysis, scenario modelling, and long-term risk planning.
Climate stress tests also influence capital allocation decisions by highlighting the resilience of green and sustainable investments relative to carbon-intensive assets. This aligns with the broader growth of sustainable finance in India, including green bonds and climate-linked lending instruments.

Challenges and Limitations

Despite its growing importance, climate risk stress testing in India faces several constraints. These include limited historical climate-financial data, methodological uncertainty, and the difficulty of translating long-term climate scenarios into near-term financial metrics. The informal nature of parts of the Indian economy further complicates risk transmission analysis.
There is also a risk of inconsistency across institutions if common standards and assumptions are not clearly defined. Addressing these challenges requires coordinated efforts among regulators, financial institutions, climate scientists, and data providers.