Building scenarios for climate stress-testing exercises

Building climate scenarios for financial risk assessment and stress-testing requires supervisors and financial institutions to conduct detailed modelling, incorporating macroeconomic transmission channels and sectoral disaggregation. It should span short and long-term horizons, as some climate risks may emerge in the near term, while the full effects may only unfold in the medium and long term. Similar to traditional stress tests, climate scenarios represent ‟possible futures" to evaluate financial institutions' capacity to absorb losses from adverse climate shocks and assess their strategies to adapt to the rising frequency and severity of such risks. This chapter first explains the need for climate scenarios and their design, highlighting their importance in maintaining financial stability. It then explores various modelling approaches to capture the macro-financial implications, with a focus on both transition risks from the shift to a low-carbon economy and physical risks like extreme weather events. By examining practical examples and incorporating both short- and long-term perspectives, the chapter emphasizes the role of macroeconomic considerations in scenario design. Finally, it identifies gaps in current practices and suggests areas for improvement, based on recent stress-testing exercises.