First ACPR climate stress test pilot exercise results

First ACPR climate stress test pilot exercise results

Wed 22 Sep 2021

Climate change introduces considerable economic challenges. On the one hand, financial institutions must contribute to the transition to a low-carbon and balanced economy to effectively combat global warming. On the other hand, the financial sector is exposed to climate-related and environmental risks and therefore needs to implement appropriate risk management practices within a financial stability framework. 

In 2022, the European Central Bank will be launching an EU-wide climate stress test in its efforts to examine the resilience of companies and banks to potential disruptions caused by climate change. Taking this into consideration, all European banks should carefully consider the outcomes and conclusions of the first climate stress test pilot exercise by the French Prudential Supervision and Resolution Authority (ACPR).

Conducted in 2020 and based on the recommendations and work of the Network of Central Banks and Supervisors for the Greening of the Financial System (NGFS), the ACPR’s exploratory exercise was designed by the teams of the Bank of France and aimed at assessing the risks associated with climate change.

The pilot exercise took place in France and mainly covered two types of risks: physical risks, initially concerning insurance, and transition risks such as the impact on profitability by increasingly high carbon taxes and consumer displacement of high carbon production.

This article summarises the findings of the pilot exercise and its main results published by the ACPR. The results discussed below are focused on transition risks.

In this innovative exercise, the ACPR’s multiple objectives achieved at this initial stage include

  • raising awareness of climate-related and environmental risks among financial institutions;
  • measuring their vulnerabilities; and
  • laying the first methodological foundations of a challenging exercise, consisting of modelling events that have never been observed, and whose timeframe is significantly longer than other stress test exercises.

To ensure consistency with the various bodies that have already taken up the subject, the ACPR has capitalised on the NGFS’s work.

NGFS transition scenarios

Figure 1.  The four NGFS scenarios. Source

The NGFS proposes four broad scenarios:

  • An orderly and predictable transition to a low-carbon economy that achieves predetermined climate goals.
  • Insufficient and late transition to limit global warming.
  • Disorderly transition involving disruptive shocks to achieve the predetermined climate goals.
  • A “hothouse world” scenario with no transition involving the materialisation of severe physical risks.

ACPR transition scenarios

For the pilot exercise, the ACPR selected three transition scenarios. Each of them combined different assumptions related to the implementation of carbon taxes and productivity levels. Two of these ACPR scenarios were calibrated to those outlined by the NGFS:

ScenarioInitial sourceCharacteristicsCarbon footprint
Reference scenario (orderly transition)NGFSNarrative of the National Low Carbon Strategy.Significant increase in the price of carbon which limits the rise in temperature to below 2⁰C.
Disordered scenario Variant 1 (late transition) NGFSGHG emission reduction target is not met by 2030.Very sharp increase in the price of carbon from 2030 ($14 in 2030 to $704 in 2050 per ton), generating a series of heterogeneous shocks on the various economic sectors and thus an increase in real energy prices.
Disordered scenario: Variant 2 (accelerated transition)ACPRLess favourable evolution of the productivity compared to the reference scenario from 2025 onwards.   Less efficient renewable energy technologies than expected, resulting in higher energy prices.Sharp increase in the price of carbon in 2025 ($14 in 2025 to $704 in 2050 per ton).

Results reveal some interesting insights

A first result identified by the exercise is that, as expected, adverse scenarios yield higher credit risk projections than the baseline scenario.

The effect of the cost of credit risk is presented in the table below:

ScenarioEvolution in the scenario between 2025 and 2050 in %Deviation from the reference scenario in 2050 in %
Reference scenario22.4%0%
Accelerated scenario32.4%8.9%
Delayed scenario27.7%3.9%
Note: The annual cost of credit risk (in basis points) for each time interval studied is the metric selected by ACPR for assessing the transition impact of credit risk.

Contrary to traditional stress tests, none of the scenarios in this pilot exercise embeds an economic recession by 2050. However, the scenarios do embed a lower growth in activity. As a result, the scenario impacts obtained are lower than those observed in the framework of the biannual stress tests of the European Banking Authority (EBA).

The breakdown of these impacts by portfolio also provides some interesting insights:

 Contribution to the increase in the cost of risk between 2025 and 2050 in the reference scenarioComments
Corporate portfolio~60%The difference in the cost of risk between the accelerated transition scenario and the reference scenario is concentrated in the corporate portfolio.   Sensitive sectors represent only 9.7% of the assets but explain one-third of the increase in the cost of risk in the reference scenario.
Household portfolio~30%Due to the small variations in macroeconomic variables between the different scenarios, the accelerated transition scenario has a limited impact (0.5%) on the household portfolio compared to the reference scenario at 2050.
Sovereign portfolio6.5%The sovereign portfolio was significantly affected by the scenarios, with a +87.5% difference between the accelerated and the reference scenario.

Beyond these results, the ACPR notes a substantial disparity in the approaches used to dynamically update the balance sheet and deduce the climate risk impacts. As a result, there are inconsistencies in the estimates, particularly affecting the climate-sensitive sectors.

Another interesting point is that the update of the balance sheet structure reveals two impacts. First, a decrease in the cost of risk due to the reduction of exposures in sectors most affected by the scenarios. Second, an increase in the cost of risk linked to the initial higher default probabilities in certain sectors benefiting from the transition.

Conclusion: more emphasis on lessons learnt

Considering the complexity of this modelling exercise, we believe it is important not to focus solely on the numerical results of this exploratory exercise, but on the lessons learnt. Indeed, The points below are essential for the upcoming European Central Bank (ECB) exercise, which will address all Single Supervisory Mechanism (SSM) banks whereby significant institutions in Europe must enhance their systems with climate management metrics, classifications and terminology, and focus on the determination and utilisation of accurate reporting and measuring tools.

  • Enrichment of the systems and know-how to be able to identify the capacity of borrowers to adapt to the profound transformations of the cost of resources and the fiscal environment linked to climate change;
  • A first wave of enhancements will consist of enriching the systems with a corporate sector classification, nomenclature adapted to climate issues, particularly concerning transition risk;
  • A second wave of enhancements will aim to determine the physical location of the entities financed and then identify the upstream (suppliers) and downstream (consumers) links to integrate the physical risks satisfactorily.
  • Establishing a data repository on lessons learnt will be a key point of success for the financial industry in addressing this complex issue.
  • Ongoing work to model the potential climate impacts by capitalising on the results of published benchmarks, but also methodological benchmarks such as the one recently proposed by the Basel Committee, “Climate-related financial risks – measurement methodologies“.

The need for a more granular approach

Within Mazars, we have built an end-to-end platform to estimate expected credit losses in IFRS and Prudential Stress Tests Frameworks. The interested reader can find a video of the presentation at the below address.

The Covid situation and the need to address new stress test approaches, such as climatic transition, have been motivations to enrich this platform with additional modules that rely on a more granular representation of the risk. These additions include sectorial GDP growth and sensitivities to climatic variables such as the increase of the carbon tax foreseen in the future.

This, in addition to assumption of balance sheet future composition, allowed us to obtain results in line with regulator expectations keeping us and our team members invested in this state-of-the-art project in terms of credit risk assessment in a fast-evolving world.

Future benchmarks and additional studies will help us all ensure the consistency of the risk estimates according to the various frameworks used by the different supervisors.