Did you know that climate risk is increasingly recognised as a major financial risk, compelling central banks and financial regulators to pioneer frameworks for green stress testing? By incorporating climate risk scenarios into financial supervision, these organisations are safeguarding economic stability while also promoting sustainable finance. Climate-driven shocks (ranging from extreme weather events to long-term transition risks) can impact asset valuations, credit quality, and market confidence. Green stress tests simulate these scenarios, enabling banks and financial entities to gauge resilience, identify vulnerabilities, and help direct strategic adaptation. This emerging discipline transforms climate concerns from an environmental issue into a critical dimension of financial oversight.
How are central banks and regulators incorporating climate risk into financial supervision?
- Scenario-based climate risk analysis: Financial supervisors have developed forward-looking scenarios that capture both physical and transition risks across different time horizons, including abrupt policy shifts and gradual warming trends. These scenarios are used in stress tests that evaluate the impacts on portfolios, credit default probabilities, and market liquidity. By quantifying climate risk exposure, regulators encourage better risk management and disclosure among financial institutions.
- Integration of climate risk into prudential frameworks: Beyond standard stress testing, regulators are embedding climate risk into capital adequacy and risk-weighted asset calculations. This pushes banks to hold buffers that reflect potential climate-related losses, aligning financial resilience with sustainable development goals. For instance, some jurisdictions require banks to adjust risk premiums for carbon-intensive sectors or consider stranded asset risks in lending decisions.
- Promoting transparency and improved data quality: The availability and consistency of climate-related financial data are key challenges in green stress testing. Thus, regulators are mandating enhanced disclosures based on frameworks like the Task Force on Climate-related Financial Disclosures (TCFD), which improves comparability and informs supervisory evaluations. This transparency supports market confidence and empowers investors to incorporate climate risks into decision-making.
How can financial institutions prepare for the new era of green stress testing?
- Develop robust climate risk frameworks: Organisations should embed scenario analysis into risk management, using climate models and external data to assess potential exposures under different climate futures.
- Enhance data governance and reporting: Creating comprehensive, high-quality climate data sets that cover physical impacts and transition pathways is fundamental for accurate stress testing and regulatory compliance.
- Engage stakeholders and build expertise: Banks must train risk officers, executives, and boards on climate risks and collaborate with regulators to better align strategies with evolving supervisory expectations.
Strategy&Ops supports financial organisations in navigating this complex landscape through tailored advisory services and capacity-building programmes. Our multidisciplinary team support the integration of climate risk, the development of bespoke green stress testing frameworks, and the strengthening of governance protocols.
Green stress testing, where climate and finance intersect decisively, marks a pivotal shift. Ready to future-proof your institution and lead in sustainable finance? Reach out to our multidisciplinary team at info@strategyandops.net.
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References
Bank of England (2025) The Bank of England’s climate-related financial disclosure 2025. Available at: https://www.bankofengland.co.uk/climate-change/the-bank-of-englands-climate-related-financial-disclosure-2025
Faint, C. (n.d.) The Bank of England’s evolving approach to climate risks. Asian Development Bank presentation. Available at: https://www.adb.org/sites/default/files/event/816571/files/day-2-session-3-speaker-3-boe-chris-faint-rev.pdf
Financial Stability Board (2025) FSB develops analytical framework and toolkit to assess climate-related vulnerabilities. Available at: https://www.fsb.org/2025/01/fsb-develops-analytical-framework-and-toolkit-to-assess-climate-related-vulnerabilities/
White & Case LLP (2025) How should EU and UK banks manage climate-related risks? Available at: https://www.whitecase.com/insight-alert/how-should-eu-and-uk-banks-manage-climate-related-risks