Climate Stress Testing

Climate stress testing is an advanced risk assessment tool used to evaluate the resilience of financial institutions and the broader financial system to climate-related shocks. In banking and finance, it examines how extreme but plausible climate scenarios may affect asset quality, capital adequacy, liquidity, and overall financial stability. For the Indian economy, climate stress testing has become increasingly important due to high exposure to climate risks, structural dependence on climate-sensitive sectors, and the growing scale and complexity of the financial system.

Concept and Evolution of Climate Stress Testing

Climate stress testing builds upon traditional financial stress testing frameworks by incorporating climate-related risk drivers. Conventional stress tests typically focus on short-term macroeconomic shocks such as recessions, interest rate movements, or exchange rate volatility. In contrast, climate stress tests integrate long-term, uncertain, and non-linear climate variables, requiring scenario-based and forward-looking analysis.
These tests assess two broad categories of climate-related financial risks. Physical risks arise from extreme weather events such as floods, cyclones, heatwaves, and droughts, as well as from gradual changes like rising temperatures and sea levels. Transition risks stem from policy measures, regulatory changes, technological innovation, and market shifts associated with the transition to a low-carbon economy. Climate stress testing evaluates how these risks transmit through the economy and the financial system under adverse conditions.

Climate Stress Testing in Banking and Finance

In the banking sector, climate stress tests are primarily used to assess the impact of climate shocks on loan portfolios, collateral values, and capital buffers. Banks analyse their exposure to climate-sensitive sectors such as agriculture, energy, transport, construction, real estate, and heavy manufacturing. Severe climate events can disrupt production, reduce borrower incomes, and impair repayment capacity, leading to higher credit losses and non-performing assets.
Climate stress testing also considers second-round effects, including macroeconomic feedback loops and contagion across financial institutions. For example, widespread infrastructure damage from floods can affect multiple sectors simultaneously, amplifying systemic risk. By quantifying potential losses under stressed climate scenarios, banks can evaluate the adequacy of capital and provisioning levels and strengthen risk management practices.

Importance for the Indian Economy

India is among the most climate-vulnerable economies due to its geographic diversity, long coastline, monsoon-dependent agriculture, and high population density. Climate-related disasters already impose significant economic costs, affecting livelihoods, infrastructure, and public finances. These vulnerabilities have direct implications for the stability of the Indian financial system.
The Indian economy’s growth model relies heavily on infrastructure investment, energy consumption, and urban expansion, all of which are exposed to both physical and transition risks. Climate stress testing helps assess how climate shocks could affect economic growth, employment, inflation, and fiscal balances, and how these macroeconomic impacts may translate into financial sector stress.
India’s commitment to climate mitigation and adaptation under the Paris Agreement further highlights the relevance of climate stress testing in understanding the financial consequences of decarbonisation and structural transformation.

Role of the Reserve Bank of India and Regulators

The Reserve Bank of India has progressively recognised climate change as a source of systemic financial risk. In recent years, the RBI has initiated efforts to incorporate climate-related risks into its supervisory and regulatory framework. These efforts include exploratory climate stress testing exercises, guidance on sustainable finance, and encouragement for banks to improve climate risk governance and disclosure.
Indian regulators are increasingly aligning with international best practices, particularly those promoted by the Network for Greening the Financial System. However, methodologies are adapted to reflect domestic economic structures, development priorities, and data availability.

Methodologies Used in Climate Stress Testing

Climate stress testing typically relies on scenario analysis rather than probabilistic forecasting. Scenarios may include:

• Orderly transition scenarios, where gradual policy action limits economic disruption.
• Disorderly transition scenarios, involving delayed or abrupt policy changes that cause sharp financial stress.
• Severe physical risk scenarios, characterised by frequent and intense climate disasters.

These scenarios are translated into sectoral and macroeconomic shocks, which are then mapped onto bank balance sheets. Stress tests estimate impacts on credit losses, profitability, and capital adequacy over medium- to long-term horizons. In India, given data constraints, stress tests often begin with sector-level or portfolio-level assessments rather than fully integrated system-wide models.

Implications for Banks and Financial Institutions

Climate stress testing has important strategic implications for Indian banks and financial institutions. It encourages better identification of concentration risks and supports the integration of climate considerations into credit appraisal, portfolio management, and internal risk limits. Over time, stress testing can influence lending patterns by highlighting the relative risks of carbon-intensive versus climate-resilient activities.
The results of climate stress tests also support capital planning and risk-based pricing, helping institutions build buffers against potential future losses. In addition, they contribute to improved transparency and disclosure, strengthening market discipline and investor confidence.

Challenges and Limitations

Despite its growing importance, climate stress testing in India faces several challenges. These include limited availability of granular climate and financial data, uncertainty around long-term climate impacts, and methodological complexity in linking climate variables to financial outcomes. The large informal sector and regional diversity of the Indian economy further complicate risk assessment.
There is also a risk that climate stress testing outcomes may be misinterpreted as forecasts rather than exploratory assessments. Ensuring appropriate use of results and avoiding mechanical regulatory responses remain key considerations.