Central Banks need to step up their Approach to Chronic Physical Risk Assessment

• While the recent NGFS survey indicates that central banks are increasingly prioritising sustainability risk management, the financial system's ability to assess and prepare for chronic physical risks remains less developed than for acute ones, potentially leaving it vulnerable to underestimated or overlooked impacts.
• By collaborating with data vendors, central banks can enhance their ability to translate chronic physical risks into potential economic impacts, leading to more informed decision-making and risk management strategies.

In May 2024, the NGFS released of its good practice and recommendations report for Sustainable and Responsible Investment (SRI) in central banks’ portfolio management, outlining findings and suggestions based on information for earlier NGFS publications, using various research methods including a new survey conducted among NGFS members in 2023 involving 55 central banks and three observers from five continents.

While the NGFS acknowledges that, while members are “progressively adopting the SRI practices”, it also stresses that there are still some areas of improvement, especially regarding climate risk assessment.

Particularly, the NGFS notes “the translation of acute physical risks into projected economic impact seems to be more developed than the translation of chronic physical risks”.

In this article, we focus on highlighting key methodological and data challenges that banks continue to face with respect to chronical physical risk assessment and examining relevant solutions that central banks could consider and why they should.

Recent NGFS survey results show that the main reasons why central banks are motivated to engage in SRI practices are for protecting against sustainability risks (including climate-related risks), reputational risks, and to set a good example.

This motivations emerge from a combination of considerations, mainly the rising climate-related threat to financial stability over the past years and the urgency to address it from various central banks around the world.

• The European Central Bank (ECB) has acknowledged the substantial threats that climate change presents to financial stability. The ECB's 2021 Economy-Wide Climate Stress Test underscored that extreme climate change scenarios could lead to significant economic damages and jeopardise the stability of the financial system. Thus, by addressing sustainability risks, the ECB aims to mitigate potential disruptions to the financial markets and ensure a stable economic environment.
• The Bank of England has also underscored the significance of addressing climate risks to ensure financial stability. In its Climate Adaptation Report of 2021, the Bank detailed the possible effects of climate change on the UK's financial system and highlighted the necessity for strong risk management structures. By giving precedence to sustainability risks, the Bank of England seeks to avert systemic financial upheavals instigated by environmental elements.
• The U.S. Securities and Exchange Commission (SEC) has likewise pinpointed climate-related risks as vital for upholding market stability and integrity, and as a result proposed new rules on climate-related disclosures necessitate that companies offer comprehensive data on their climate risks and the possible effects on their financial results. This initiative is intended to safeguard investors and guarantee that the markets stay robust in the face of climate-related disturbances.

More importantly, the NGFS report suggests that survey results between 2019 and 2023 show a progress in prioritising sustainability risk management.

At the regional level for example, the ECB has already stressed in 2023 that, as part of its SSM (Single Supervisory Mechanism) supervisory priorities 2024-2026 strategy to address key banks’ vulnerabilities, “supervised institutions will primarily be asked to strengthen their resilience to immediate macro-financial and geopolitical shocks (Priority 1), as well as accelerate the effective remediation of shortcomings in governance and management of C&E [climate-related and environmental] risks (Priority 2) and make further progress in their digital transformation and building robust operational resilience frameworks (Priority 3)”.

This depicts a change from its 2022-2024 priorities strategy, where C&E risks were ranked Priority 3.

It is equally important to note that, in the context of climate-related risks, the growing consideration to address sustainability risks in banking supervision is in part due to recent industry progress in understanding of nature and magnitude of climate physical risks occurrences (idiosyncratic) and estimated impacts (through stress testing and scenario analysis) on exposed assets and their market values over time.

The 2022 EU banking sector’s climate stress test showed that while corporate loans contribute significantly to climate risk, covered bonds and asset-backed securities (ABSs) presents higher risks under the NGFS-based “hot house world” scenario, showing also an increase in chronic physical risk.

According to the NGFS however, the process of converting acute physical risks into anticipated economic impacts is more advanced than the process of doing the same for chronic physical risks.

In other words, the financial system is better at assessing and preparing for sudden, severe events (like natural disasters) than it is for slower, more persistent changes (like rising sea levels or increasing temperatures).

This could potentially leave the system vulnerable to these chronic risks, as their economic impact may be underestimated or overlooked.

In a keynote speech delivered on 12 April 2024 at the Delphi Economic Forum XI, Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, stated that “if decisive action is not taken now, most climate risks could reach critical or catastrophic levels by the end of this century”. 

This underscores the urgency to prioritise the treatment of chronic physical risks in particular and addressing challenges related to their technical assessment, including methodological and data gaps.

While there are still debates on how to improve the translation of chronic physical risks into projected economic impacts, more solid recommendations that are still valuable to this day have emerged.

In a 2023 report on banks’ progress in climate stress test and scenario analysis in Europe, the Association for Financial Markets in Europe (AFME), in conjuncture with Oliver Wyman, suggests that “banks need better understanding of transmission channels for physical risks and improved data governance to support long-term projections of physical risks in future exercises”.

In the context of data governance, all banks surveyed by AFME proposed to improve collaboration with external data providers, as they heavily (87%) rely on the latter for physical data.

However, this also underscores persisting challenges to adequately collect and manage data, considering limitations to access forward-looking, relevant and reliable data.

As the ECB is expecting supervised banks to fully integrate climate-related considerations in their risk management landscape by the end of 2024, Marie-Stéphanie Diouf, Senior Risk Manager of ESG risk at BNP Paribas, precises that “the key challenge is related to financed asset data (location, type of assets, size and strategic importance), and to the development and integration of models that allow a proper assessment of these risks”.

Further adding: “to gain a net view of the risk, we must take into account the possible adaptation measures for our customers and insurance cover, as well as the support offered by governments through natural catastrophe funds”.

In this regard, it is important to note that external data vendors, such as Climate X, can play a crucial role in helping central banks better understand and manage chronic physical risks. Here’s how:

1. Data Governance: Data vendors can provide expertise in managing and governing large datasets, ensuring data quality and reliability. This is particularly important when dealing with complex climate data.
2. Data Collection and Analysis: They can gather and analyse a wide range of climate-related data, including long-term trends in temperature, precipitation, sea levels, and more. This data can help central banks understand the potential physical risks associated with different climate scenarios.
3. Risk Modelling: Using advanced algorithms and machine learning techniques, data providers can help central banks develop more accurate models for predicting the economic impact of chronic physical risks.
4. Scenario Analysis: They can assist in creating various climate risk scenarios, including worst-case scenarios. This can help central banks better prepare for potential future risks.