Sustainability Atlas
Climate Finance & Markets·11 min read··...

Trend watch: Climate risk stress testing & scenario regulation in 2026 — signals, winners, and red flags

Signals to watch, value pools, and how the landscape may shift over the next 12–24 months. Focus on KPIs that matter, benchmark ranges, and what 'good' looks like in practice.

The 2025 EU-wide stress test revealed that climate risks would deplete bank capital by 74 basis points for transition risk and 77 basis points for acute physical risk—demonstrating that regulatory stress testing has evolved from theoretical exercise to material capital planning concern (European Banking Authority, 2025). For sustainability leads navigating the intersection of climate risk management and financial regulation, the signals emerging from central banks and supervisory authorities across the EU now define the operational requirements for the next 12-24 months.

Why It Matters

Climate risk stress testing has transitioned from voluntary disclosure enhancement to regulatory imperative. The European Central Bank set a deadline for banks to meet supervisory expectations on climate-related and environmental risks by end of 2024, with expanded climate change work continuing through 2025. This timeline convergence—CSRD's first reporting wave, ECB supervisory enforcement, and EBA's integration of climate into the EU-wide stress testing framework—creates a concentrated implementation burden that sustainability leads must manage simultaneously.

The financial stakes are substantial and growing. Climate-related losses exceeded $310 billion in 2024, and traditional risk models systematically underestimate climate impacts by as much as 70% according to analysis by Green Central Banking. The NGFS damage function incorporated into regulatory scenarios—projecting 19% loss of global real income by 2050 under baseline warming—underwent methodological scrutiny in late 2024 that has not yet been resolved, adding uncertainty to capital planning exercises.

For EU-based financial institutions, the regulatory trajectory is clear even as methodological debates continue. The Basel Committee on Banking Supervision published its voluntary framework for disclosure of climate-related financial risks in June 2025, signaling that current European requirements are likely to cascade globally. Sustainability leads who build robust stress testing capabilities now position their institutions for competitive advantage as requirements tighten.

Key Concepts

Regulatory Stress Test Architecture

Climate stress testing operates within a layered regulatory architecture, with distinct but interconnected requirements:

ECB Supervisory Expectations: Direct supervision of significant institutions (SIs) with specific requirements for climate risk integration into ICAAP (Internal Capital Adequacy Assessment Process). The ECB chairs the NGFS workstream on Scenario Design and Analysis, ensuring alignment between supervisory practice and scenario development.

EBA EU-wide Framework: Coordinates standardized stress testing across member states, with gradual incorporation of climate risk. The 2025 exercise included climate analysis showing 74 bp (transition) and 77 bp (physical) CET1 capital impacts—material but not yet threatening solvency thresholds.

National Competent Authorities: Implement ECB guidance with local market adaptations. Varying implementation timelines and methodological preferences create compliance complexity for cross-border institutions.

Regulatory BodyCurrent StatusKey RequirementTimeline
ECBActive enforcementClimate risk in ICAAP/ILAAPEnd 2024 deadline
EBAIntegration ongoingEU-wide stress test inclusionAnnual cycle
PRA (UK)Consultation activeCCAR 2025 publishedApril 2025 guidance
BCBSVoluntary frameworkDisclosure standardsJune 2025 published
FSBRoadmap updateVulnerability assessment toolkitJanuary 2025

NGFS Scenario Framework

The Network for Greening the Financial System provides the dominant scenario architecture for regulatory stress testing:

Long-term Scenarios: Updated with new economic and climate data, policy commitments, and model versions. Standard scenarios include Net Zero 2050, Below 2°C, National Determined Contributions (NDC), and Current Policies pathways.

Short-term Scenarios: Published May 2025, focusing on "extreme but plausible" events that could trigger systemic risks over 3-5 year horizons. These bridge the gap between long-term transition narratives and near-term capital planning requirements.

Phase V Damage Function Controversy: The November 2024 incorporation of Kotz et al. damage estimates generated significant debate. Nature issued a warning regarding methodology reliability, and academic critiques were published in August 2025. Institutions must navigate this uncertainty while regulators have not yet updated guidance.

Credit Model Adaptation Requirements

Banks face significant technical challenges adapting existing Basel IRB credit models to incorporate climate risk:

  • Probability of Default (PD) adjustments: Requires sector-specific carbon elasticity estimates and policy scenario sensitivity analysis
  • Geolocation data integration: Physical risk assessment demands precise asset coordinates, often unavailable for SME and consumer exposures
  • Scope 1-3 emissions attribution: Counterparty-level emissions data necessary for transition risk but frequently relies on spend-based proxies with 30-50% uncertainty
  • Non-linear risk dynamics: Historical loss data cannot capture tipping points and feedback loops inherent to climate risk

What's Working

Phased Implementation with Materiality Focus

Institutions achieving supervisory approval are adopting staged approaches that prioritize material exposures before attempting comprehensive portfolio coverage.

Example: ING Group—The Dutch banking group implemented climate stress testing across its highest-carbon exposures (oil & gas, utilities, heavy manufacturing) first, demonstrating supervisory compliance before extending to the full lending book. Their 2024 Climate Report disclosed scenario-specific impairment estimates that satisfied ECB expectations while acknowledging remaining methodological limitations. This transparency-forward approach has become a model for peers navigating similar regulatory conversations.

Sector-Specific Transition Pathway Libraries

Banks developing granular sector decarbonization pathways—rather than relying solely on top-down macro scenarios—demonstrate stronger analytical defensibility in supervisory reviews.

Example: BNP Paribas—The bank built internal transition pathway models for 22 high-emission sectors, enabling counterparty-level transition risk assessment. Their approach integrates IEA sectoral projections with proprietary client engagement data on decarbonization plans, creating a forward-looking credit perspective that moves beyond historical emissions analysis. Regulators have cited this as representing evolving best practice.

Integrated Physical-Transition Scenario Analysis

Leading institutions recognize that physical and transition risks interact dynamically. Severe physical impacts accelerate policy responses (transition risk), while rapid transition can strand assets before physical risks fully materialize.

Example: Zurich Insurance Group—Their Climate Resilience Solutions division developed integrated scenario models that capture physical-transition feedback loops. A November 2024 launch of "Zurich Climate Spotlight" combined satellite-derived physical exposure data with transition pathway analysis for commercial real estate portfolios. This integrated approach addresses supervisory concerns about siloed risk treatment.

What's Not Working

Static Scenario Extrapolation

Institutions relying on simple linear extrapolation of NGFS macro scenarios to individual counterparties face supervisory pushback. The EBA and ECB have indicated that mechanistic application without firm-specific analysis does not meet supervisory expectations. This affects institutions that purchased standardized stress testing solutions without adequate customization capacity.

Underinvestment in Data Infrastructure

Physical climate risk models require asset-level geolocation data that many banks lack. Reliance on headquarters locations as proxies for distributed operations significantly underestimates exposure. A 2024 Green Central Banking analysis estimated that traditional approaches understate physical risk by up to 70%—a gap that regulators are increasingly scrutinizing.

Governance Fragmentation

Climate risk stress testing frequently falls between traditional risk management functions and sustainability teams, creating accountability gaps. The ECB has specifically criticized institutions where climate risk lacks clear governance ownership, sufficient board-level engagement, or integration with strategic planning processes.

Methodological Uncertainty Paralysis

The NGFS damage function controversy has led some institutions to delay implementation pending methodological resolution. This approach carries regulatory risk—supervisors expect demonstrated progress even amid academic debate. The Financial Stability Board's January 2025 framework explicitly acknowledges that "historical data is inadequate for analyzing nonlinear climate risks" while still requiring forward-looking assessment.

Key Players

Established Leaders

  • European Central Bank: Sets supervisory expectations and chairs NGFS Scenario Design workstream. Their expanded 2024-2025 climate agenda includes contributing to the "Fit-for-55" stress test and financial stability analysis.

  • European Banking Authority: Coordinates EU-wide stress testing with gradual climate integration. Final climate stress testing guidance expected early 2026 following September 2025 consultation closure.

  • Bank of England / PRA: Published Climate Change Adaptation Report 2025 (January) and consultation paper CP10/25 (April 2025) on climate risk management for banks and insurers. Leading on climate-financial stability intersection.

  • Network for Greening the Financial System (NGFS): Provides scenario architecture used across jurisdictions. 140+ member central banks and supervisors. May 2025 short-term scenario publication represents significant methodology advancement.

Emerging Startups

  • Riskthinking.AI: Toronto-based climate stress testing platform founded by former TCFD Secretariat members. Provides scenario analysis tools specifically designed for regulatory compliance. Series B funding closed 2024.

  • ClimateCheck: Offers physical risk assessment at property level for commercial real estate and mortgage portfolios. Expanding European operations following UK success.

  • Planetrics (acquired by McKinsey): Climate scenario modeling platform now integrated into McKinsey's Sustainability practice. Widely used by European banks for regulatory stress testing engagements.

  • Risilience: UK-based climate scenario platform focused on transition risk and decarbonization pathway analysis. Particular strength in heavy industry sector modeling.

Key Investors & Funders

  • BIS Financial Stability Institute: Developed Climate Training Alliance portal for capacity building across emerging market central banks and supervisors.

  • European Investment Bank: Provides technical assistance for climate stress testing capability development through InvestEU advisory services.

  • ClimateWorks Foundation: Funds research on climate-financial system interactions informing regulatory methodology development.

  • Green Climate Fund: Supports capacity building for climate risk assessment in developing country financial supervisors.

Sector-Specific KPI Benchmarks

MetricPoorAdequateGoodExcellent
Portfolio coverage (climate assessment)<30% by exposure30-60%60-85%>85%
Scenario granularityNGFS macro onlySector overlaysCounterparty-specificDynamic pathways
Physical risk resolutionCountry-level proxiesRegionalAsset-level sampleFull geolocation
Governance integrationSustainability siloRisk committee reportingBoard-level ownershipStrategic planning integration
Data quality (emissions)Spend-based onlySector averagesReported where availableVerified comprehensive
Regulatory alignmentPartial TCFDFull TCFDISSB-readyMulti-jurisdictional

Action Checklist

  • Map current climate stress testing capabilities against ECB supervisory expectations and identify specific gaps requiring remediation
  • Establish clear governance ownership for climate risk stress testing spanning risk, finance, and sustainability functions
  • Develop or procure sector-specific transition pathway models for material high-emission exposures
  • Conduct geolocation data quality assessment for physical risk-relevant portfolios (commercial real estate, project finance, structured products)
  • Document methodological choices and uncertainty ranges—transparency regarding limitations is essential for supervisory acceptance
  • Build board-level climate risk reporting capabilities including scenario comparison and capital impact quantification
  • Monitor NGFS damage function debate and prepare for potential methodology updates in 2026 guidance

FAQ

Q: How should institutions handle the NGFS Phase V damage function uncertainty? A: Regulators expect continued progress despite methodological debate. Best practice involves: (1) using NGFS scenarios as baseline while documenting known limitations, (2) running sensitivity analysis across alternative damage function specifications, (3) clearly disclosing assumptions and uncertainty ranges in stress test documentation, and (4) monitoring NGFS updates for methodology revisions expected in 2026. Paralysis is not an acceptable response.

Q: What capital implications should sustainability leads anticipate from climate stress testing? A: The 2025 EU-wide stress test showed 74-77 bp CET1 depletion from climate scenarios—material but below crisis thresholds. However, these estimates likely understate tail risks. Sustainability leads should work with finance colleagues to model Pillar 2 capital add-on scenarios ranging from 0.25-1.0% CET1 equivalent, depending on portfolio concentration in high-emission sectors and physical risk exposure geographies.

Q: How does CSRD climate disclosure interact with regulatory stress testing? A: CSRD ESRS E1 requires disclosure of climate scenario analysis and transition planning—overlapping significantly with stress testing requirements. However, CSRD focuses on strategy and targets while regulatory stress testing emphasizes capital adequacy. Integrated approaches that serve both purposes reduce duplication: build scenario analysis capabilities that generate both CSRD narrative content and supervisory quantitative outputs.

Q: What timeline should institutions plan for to achieve full compliance? A: ECB expectations applied from end of 2024, meaning institutions should already demonstrate meaningful progress. Full integration—including counterparty-level transition risk assessment, asset-level physical risk mapping, and governance integration—typically requires 18-24 months for large institutions. Those starting now should target end of 2027 for comprehensive capabilities while demonstrating incremental progress throughout.

Q: How are non-EU institutions affected by EU climate stress testing requirements? A: Non-EU banks with significant EU operations face consolidated supervision requirements. Global systemically important banks (G-SIBs) increasingly apply EU-equivalent standards globally for operational consistency. The Basel Committee's June 2025 voluntary framework signals future convergence toward mandatory climate stress testing across major jurisdictions. Early adoption positions institutions for regulatory change regardless of home jurisdiction.

Sources

Topics

riskstressgreen bondsportfolio constructionWACCunderwritingTCFD

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