Myth-busting Climate risk stress testing & scenario regulation: separating hype from reality

By 2025, over 85% of global systemically important banks had conducted at least one climate stress test, yet fewer than 15% reported that results materially influenced capital allocation decisions. This disconnect between regulatory compliance and practical risk management reveals a fundamental tension at the heart of climate stress testing: the gap between what supervisors hope these exercises achieve and what they actually deliver. As central banks from Frankfurt to Washington mandate increasingly sophisticated scenario analyses, distinguishing evidence-based risk assessment from compliance theater has become essential for investors, risk managers, and policymakers alike.

Why It Matters

Climate stress testing has moved from the periphery to the center of prudential supervision in less than five years. The European Central Bank's 2022 climate stress test covered 104 banks representing €24 trillion in assets and exposed significant data gaps, with 60% of participating institutions unable to provide granular emissions data for their corporate loan portfolios. The Bank of England's Climate Biennial Exploratory Scenario (CBES) concluded that major UK banks could face combined losses of £225 billion under a delayed transition scenario, representing approximately 10% of their total assets.

These exercises have regulatory teeth. The ECB identified €70 billion in underprovisioned climate-related exposures during its 2024 review cycle, directly impacting Pillar 2 capital requirements for 14 institutions. Meanwhile, the Federal Reserve's pilot climate scenario analysis in 2023 included the six largest US bank holding companies and signaled the Fed's intent to integrate climate considerations into the supervisory framework, albeit more cautiously than European counterparts.

The stakes extend beyond banking. Asset managers overseeing more than $130 trillion in assets under management now face mandatory climate scenario disclosure requirements under the EU's Sustainable Finance Disclosure Regulation (SFDR) and similar frameworks in the UK, Singapore, and Japan. Insurance supervisors have launched parallel exercises, with the European Insurance and Occupational Pensions Authority (EIOPA) finding that €170 billion in European insurer assets could be stranded under accelerated transition scenarios.

For investors, understanding what climate stress tests actually measure—and what they systematically miss—is crucial for interpreting both regulatory signals and portfolio risk exposures.

Key Concepts

Climate Stress Testing Fundamentals

Climate stress testing applies forward-looking scenario analysis to assess how physical and transition risks could impact financial institution balance sheets. Unlike traditional stress tests that typically examine 1-3 year horizons, climate exercises must grapple with 30-year projection windows that exceed most institutions' strategic planning cycles. This temporal mismatch creates inherent modeling challenges that practitioners must navigate.

NGFS Scenarios and Transition Pathways

The Network for Greening the Financial System (NGFS), comprising 134 central banks and supervisors, has established the de facto standard scenario framework. The NGFS scenarios range from orderly transitions (Net Zero 2050) through disorderly transitions (Delayed Transition) to physical risk-dominated futures (Hot House World). Each scenario provides macroeconomic variables, carbon prices, sectoral output pathways, and physical climate parameters through 2100.

The 2023 NGFS scenario update incorporated improved physical risk modeling and sectoral granularity, yet significant gaps remain. The scenarios assume globally coordinated policy responses that may not materialize, and they struggle to capture regional heterogeneity in transition pathways.

Capital Adequacy Implications

Climate stress test results increasingly flow into Pillar 2 capital requirements under Basel III frameworks. The ECB's 2024 supervisory guidance specifies that banks with material climate risk exposures and inadequate risk management must hold additional capital buffers. This represents a shift from climate stress testing as a learning exercise to a binding constraint on bank capital.

Prudential Regulation Evolution

Supervisors are moving from voluntary guidance to mandatory requirements. The UK Prudential Regulation Authority (PRA) expects firms to fully embed climate risk management by 2025, with climate scenario analysis integrated into Internal Capital Adequacy Assessment Processes (ICAAPs). Similar transitions are occurring across Asia-Pacific jurisdictions, creating a patchwork of requirements that internationally active institutions must navigate.

Climate Stress Testing KPI Metrics

Metric	What It Measures	Typical Range	Key Limitations
Transition Risk Exposure Ratio	Share of portfolio in high-carbon sectors	15-40% for commercial banks	Sector definitions vary across jurisdictions
Physical Risk Coverage	Percentage of assets with geocoded physical risk data	30-75%	Quality depends on counterparty disclosure
Scenario-Weighted Expected Loss	Credit losses under specific NGFS pathways	2-8% of exposures	Highly sensitive to model assumptions
Green Asset Ratio	EU Taxonomy-aligned exposures vs. total assets	3-12% for European banks	Taxonomy scope limitations
Climate VaR	Value-at-risk adjusted for climate scenarios	+15-50% vs. baseline VaR	Model uncertainty exceeds traditional VaR
Carbon Intensity	Financed emissions per million euros lent	150-600 tCO2e/€M	Scope 3 data quality challenges
Transition Plan Alignment Score	Degree of alignment with sectoral decarbonization	20-65% across major banks	No standardized methodology

What's Working and What Isn't

What's Working

ECB and BoE Supervisory Integration: European supervisors have successfully integrated climate stress test findings into ongoing supervisory dialogue. The ECB's 2024 thematic review resulted in 85% of identified deficiencies receiving formal supervisory expectations, with institutions required to demonstrate remediation progress. The Bank of England's iterative approach through CBES has built institutional capacity, with participating banks reporting meaningful improvements in data infrastructure and modeling capabilities.

NGFS Scenario Adoption and Standardization: The NGFS framework has achieved remarkable adoption velocity. Over 100 jurisdictions now reference NGFS scenarios in supervisory guidance, creating a common language for climate risk assessment. This standardization enables cross-border comparability that was impossible five years ago and facilitates knowledge sharing among institutions.

Disclosure Requirement Acceleration: Mandatory climate disclosure, anchored by stress testing requirements, has driven substantial improvements in corporate emissions reporting. The percentage of MSCI World companies disclosing Scope 1 and 2 emissions increased from 62% in 2020 to 89% in 2024, partly driven by financial institution data demands for stress testing purposes.

Sectoral Pathway Development: Industry initiatives have produced granular transition pathways for hard-to-abate sectors. The Science Based Targets initiative's sectoral guidance and the Transition Pathway Initiative's carbon performance benchmarks provide reference points that stress testing exercises increasingly incorporate.

What's Not Working

Methodology Inconsistency: Despite NGFS standardization at the scenario level, translation into institution-specific impacts remains highly variable. A 2024 BIS study found that banks applying the same NGFS scenario to similar portfolios produced loss estimates varying by a factor of three. This methodological divergence undermines comparability and raises questions about result reliability.

Data Limitations and Quality Gaps: Physical asset geocoding remains incomplete across most portfolios. The ECB found that 40% of corporate exposures lacked sufficient data for physical risk assessment, and Scope 3 emissions data—critical for assessing financed emissions—remained unavailable or unreliable for approximately 65% of corporate lending exposures.

Time Horizon Mismatch: Climate risks materialize over decades, but bank planning horizons rarely exceed five years. This temporal disconnect creates strategic planning gaps that stress tests identify but cannot resolve. Supervisors struggle to translate 30-year scenario impacts into near-term supervisory actions without arbitrary truncation.

Static Balance Sheet Assumptions: Most exercises assume fixed balance sheet composition, ignoring management actions that would occur under stress. This static assumption systematically overestimates losses while underestimating adaptation capacity, limiting the practical utility of results for strategic planning.

Physical Risk Modeling Immaturity: While transition risk modeling has advanced significantly, physical risk assessment lags substantially. Catastrophe models developed for insurance applications require significant adaptation for banking portfolios, and the interaction between acute physical events and chronic physical changes remains poorly captured.

Key Players

European Central Bank (ECB): The ECB has emerged as the most assertive climate risk supervisor globally, conducting the largest climate stress test to date and integrating findings into binding Pillar 2 requirements. The ECB's Climate Risk Stress Test Guide sets methodological standards that influence global practice.

Bank of England / Prudential Regulation Authority (PRA): The BoE pioneered climate scenario analysis through CBES and continues to evolve its approach. The PRA's SS3/19 supervisory statement remains a reference framework for climate risk governance expectations.

Federal Reserve System: The Fed entered climate supervision cautiously but has accelerated engagement since 2023. The pilot climate scenario analysis and subsequent guidance on climate-related financial risk represent significant policy evolution, though the Fed remains more hesitant than European counterparts to impose capital implications.

Network for Greening the Financial System (NGFS): As the central forum for climate-focused central bank cooperation, NGFS shapes the conceptual framework that individual supervisors implement. NGFS scenario updates and methodological guidance directly influence stress testing practices globally.

Bank for International Settlements (BIS): The BIS provides the analytical backbone for climate risk supervision through its research and standard-setting role in the Basel Committee. BIS publications on climate risk measurement and management inform supervisory approaches worldwide.

European Insurance and Occupational Pensions Authority (EIOPA): For insurers and pension funds, EIOPA's climate stress testing framework complements banking supervision and addresses sector-specific issues including liability-side climate exposures.

Myths vs. Reality

Myth 1: Climate Stress Tests Accurately Predict Future Losses

Reality: Climate stress tests are exploratory exercises, not forecasts. The 30-year projection windows, uncertain policy pathways, and unprecedented nature of climate transition make point predictions meaningless. The value lies in identifying vulnerabilities and stress testing management processes, not in the specific loss numbers produced. Supervisors increasingly emphasize this learning function over precise quantification.

Myth 2: Passing a Climate Stress Test Means a Bank Is Climate-Resilient

Reality: Current stress tests have significant blind spots. They typically underweight tail physical risks, assume orderly scenarios, and rely on incomplete data. A bank may perform well on standardized scenarios while harboring concentrated exposures to risks outside scenario parameters. Climate stress test results should inform, not replace, comprehensive climate due diligence.

Myth 3: NGFS Scenarios Cover All Relevant Climate Pathways

Reality: NGFS scenarios deliberately exclude the most disorderly outcomes—geopolitical fragmentation, technological discontinuities, or cascading tipping points—that could generate the largest financial impacts. The scenarios provide useful central cases but leave significant tail risks unexplored. Sophisticated institutions supplement NGFS scenarios with proprietary extreme scenarios.

Myth 4: Climate Stress Testing Is Primarily About Capital Requirements

Reality: While capital implications receive attention, supervisors emphasize governance, strategy, and risk management improvements as primary objectives. The ECB's findings highlighted data and governance deficiencies as more significant than capital shortfalls. Institutions focusing solely on capital outcomes miss the broader supervisory intent.

Myth 5: Transition Risk Is More Important Than Physical Risk

Reality: Transition risk dominates current stress testing because it is more tractable to model, not because it represents greater financial exposure. Physical risk modeling remains immature, but this reflects methodological challenges rather than relative risk magnitude. Climate science suggests physical risks may ultimately dominate, particularly under delayed transition scenarios.

Myth 6: Climate Stress Test Results Are Comparable Across Institutions

Reality: Despite scenario standardization, methodological choices in exposure mapping, loss given default assumptions, and sectoral classifications produce results that are not directly comparable. A bank reporting lower climate losses may simply have made more optimistic modeling choices rather than holding a more resilient portfolio.

Action Checklist

• Conduct a gap analysis comparing current climate data infrastructure against ECB and PRA expectations, prioritizing Scope 3 emissions and physical asset geocoding
• Establish a cross-functional climate scenario governance framework linking risk, strategy, and finance functions with clear escalation pathways to board level
• Develop institution-specific scenario extensions that supplement NGFS pathways with tail risk scenarios relevant to portfolio concentrations
• Implement dynamic balance sheet modeling capabilities that capture realistic management actions under climate stress scenarios
• Build sectoral transition pathway alignment tools that map portfolio exposures against credible decarbonization trajectories
• Create a regulatory horizon scanning process to track evolving climate stress testing requirements across operating jurisdictions
• Engage external validation of climate stress testing methodologies to identify blind spots and benchmark against peer approaches

FAQ

Q: How do climate stress test results impact bank capital requirements? A: Under current frameworks, climate stress test results primarily influence Pillar 2 capital add-ons rather than Pillar 1 minimum requirements. Supervisors use findings to assess risk management adequacy and may impose additional capital buffers for institutions with material climate exposures and governance deficiencies. The ECB has indicated that qualitative findings—data gaps, governance weaknesses—carry as much weight as quantitative loss estimates in determining supervisory responses.

Q: What is the relationship between TCFD disclosure and climate stress testing? A: TCFD recommendations and climate stress testing are complementary but distinct. TCFD provides a disclosure framework for communicating climate risks to stakeholders, while stress testing is a supervisory tool for assessing capital adequacy. However, the scenario analysis pillar of TCFD aligns closely with stress testing practices, and many institutions use stress test outputs to inform TCFD disclosures. The transition to ISSB standards from 2024 reinforces this connection.

Q: How should investors interpret climate stress test disclosures? A: Investors should treat published climate stress test results as indicative rather than definitive. Focus on the qualitative findings—data gaps identified, governance improvements required, concentration risks highlighted—rather than headline loss numbers. Compare methodology descriptions across peer institutions to assess result comparability. Pay particular attention to how institutions plan to address identified deficiencies.

Q: Are climate stress tests becoming mandatory globally? A: The trajectory is toward mandatory requirements, though the pace varies significantly. The EU, UK, and Singapore have established binding expectations. The US remains more cautious, with the Federal Reserve framing exercises as pilots. Emerging markets are generally earlier in their supervisory journeys. Expect mandatory climate scenario analysis for systemically important institutions to become global standard practice by 2027.

Q: What distinguishes high-quality climate stress testing from compliance theater? A: High-quality exercises integrate findings into strategic decision-making, continuously improve data and methodology, supplement standardized scenarios with institution-specific analysis, and engage senior leadership in result interpretation. Compliance theater is characterized by minimal resource allocation, static annual exercises without methodology evolution, and findings that never influence capital allocation or strategy. The key differentiator is whether stress testing changes behavior.

Sources

• European Central Bank. "2022 Climate Risk Stress Test: Results and Key Findings." ECB Banking Supervision, July 2022.
• Bank of England. "Results of the 2021 Climate Biennial Exploratory Scenario (CBES)." Bank of England Report, May 2022.
• Network for Greening the Financial System. "NGFS Climate Scenarios for Central Banks and Supervisors: Technical Documentation." NGFS Secretariat, November 2023.
• Bank for International Settlements. "Climate-related Risk Drivers and Their Transmission Channels." BIS Working Papers No. 1049, October 2024.
• Financial Stability Board. "Supervisory and Regulatory Approaches to Climate-related Risks: Final Report." FSB, October 2024.
• European Insurance and Occupational Pensions Authority. "Sensitivity Analysis of Climate-change Related Transition Risks." EIOPA Financial Stability Report, December 2023.
• Basel Committee on Banking Supervision. "Principles for the Effective Management and Supervision of Climate-related Financial Risks." BIS, June 2022.