Discussion paper

DP17921 Climate Risk Stress Testing: A Conceptual Review

We conceptually review Climate Risk Stress Testing (CRST) approaches to assess the impact of climate-related shocks on financial system stability. We distinguish between climate, economic, and financial modeling steps, and identify six types of climate shocks and four different approaches (macro-financial, micro-financial, non-structural, and disaster risk). Our review identifies several key limitations in current CRST approaches: (i) neglect of certain climate shock types (Green Swan and Minsky-type events); (ii) overreliance on macro models (with low sectoral and spatial granularity); (iii) incomplete modeling (lack of feedback effects); and (iv) limited scope (subset of causal channels and asset classes). We argue that these limitations may lead to significant underestimation of potential system-wide financial losses and offer suggestions for improving CRST approaches.

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Citation

Reinders, H, D Schoenmaker and M Van Dijk (eds) (2023), “DP17921 Climate Risk Stress Testing: A Conceptual Review”, CEPR Press Discussion Paper No. 17921. https://cepr.org/publications/dp17921