Measuring climate-related financial risks using scenario analysis

Climate change – through both physical impacts and the effects of economies transitioning to net zero – poses financial risks in both the short and long term. These risks are relevant to a wide range of institutions across the financial system. This includes the Bank of England, given its significant financial operations. However, these risks are challenging to quantify, which could limit financial institutions’ abilities to mitigate against these risks into the future. This article explores how central banks and financial institutions can use scenario analysis to quantify these risks. It focuses on how financial institutions can ‘extend’ macro-climate scenarios to undertake granular asset-level analysis of financial risks, drawing on examples across sovereign bonds, corporate bonds and residential mortgages. It also discusses how scenario analysis outputs can be applied to financial institutions’ existing financial modelling toolkits. While scenario analysis applied in this way is at the cutting edge of climate financial risk measurement, it is still subject to a number of limitations.