Climate-related stress-testing: Transition risks

Pierpaolo Grippa and Samuel Mann

Climate-related “transition risk” is the risk stemming from the transition to a “low carbon economy” – that is, an economy that emits fewer greenhouse gases (GHG).¹¹ See Grippa and Mann (2020), Appendix I, for a description of the main greenhouse gases. It can be driven by various factors, such as changes in policy and advances in technology, as suggested by Vermeulen et al (2018), or shifts in market sentiment (TCFD, 2017). An example for a policy shock would be a top-down decision to significantly reduce GHG emissions, including through the imposition of a carbon tax. Technological advances, on the other hand, are likely to reduce the cost of alternative sources of energy, potentially leaving fossil fuels and other GHG-emitting assets “stranded”.

The integration of climate-related risks in the stress-testing framework is at the top of the agenda for private financial institutions, central banks and financial regulators (such as the Network for Greening the Financial System); it is also a high priority for international financial institutions such as the World Bank and the International Monetary Fund (IMF).

In this chapter, three approaches are proposed to quantify