We often hear of banks and insurance companies undertaking stress tests as a glimpse of how well they would fare in various scenarios of instability. The U.S. Federal Reserve requires America’s largest banks to go through stress tests each year. This is to understand the banks’ financial health by assessing their ability to withstand a serious economic downturn.
Financial regulators can also request for stress tests to be carried out to assess specific risks. For example, in 2021, the Financial Supervisory Commission (FSC 金管會) of Taiwan requested domestic banks to conduct stress tests to understand the impact of low-interest rates and the pandemic on their capital resiliency. The results showed that Taiwan’s financial sector performed well on its risk-bearing capacities and capital adequacy during the pandemic.
As a sign of our climate future, financial regulators abroad have started to order stress tests to monitor risks posed by climate change to economic stability. These climate stress tests are different from ‘traditional’ stress tests in that they require institutions to focus on their exposure to climate change risks. The central aim is to build resilience into how financial institutions would fare in various scenarios of global warming.
These tests are peepholes to the huge financial losses associated with an unmitigated increase in our global temperature.
Taiwan Stress Tests
I had written earlier that climate change has disproportionate effects on the fate of small islands. Taiwan, like other island states, is very exposed to the risks of a warming sea. In various scientific models, Taiwan would lose valuable coastal land to a rising sea and sustain heavy economic losses.
In August 2020, the FSC updated its Green Finance Action Plan, previously released in 2017. The updated plan added green prudential supervision, which included the call “to prompt financial institutions to examine [their] climate-related risks…and their ability to address such risks” (page 23).
The FSC emphasized that financial institutions need to understand their exposure risks to climate change and begin to build resilience. In December 2021, the FSC held a Sustainable Finance Workshop, and referenced lessons learnt by financial regulators in the United Kingdom and the Netherlands. Both these countries have produced concrete guidance for their banks and insurers to analyze and assess climate risks, as well as to identify opportunities for green investments.
In June 2022, FSC Banking Bureau Deputy Director-General Roger Lin (林志吉) announced that Taiwan’s banks will undergo mandatory climate stress tests in early 2023. These tests will inform regulators on the impact of various climate change scenarios on lenders’ assets. Results will be published in 2023.
Climate Change Financial Risks
Financial stress tests are technical assessment tools. In this category, climate stress tests require the consideration of climate-related factors and risks. They are different from standard assessments on capital adequacy.
The task of coming up with a template for Taiwan’s first mandatory climate stress test is currently sat with Taiwan’s Bankers Association (銀行公會), who will submit a draft to the FSC by the end of September 2022.
A central challenge for the Bankers Association in this important task will be to set the technical parameters for the forward-looking climate stress test. Climate change is an area of science that necessitates a long time horizon of 30 to 50 years for risks to fully materialise. This is in contrast to the three to five years horizon for a traditional stress test.
At the same time, a long time horizon does not supplant the need to integrate short-term and medium-term effects into the climate risk assessment. This is for the simple reason that we are already witnessing negative climate impacts, such as more frequent extreme weather events and higher recorded temperatures.
Some Taiwanese financial institutions have reportedly begun to assess climate-related risks to their real estate and loan portfolios. Assessing property loss, however, is only the beginning of appreciating how unmitigated climate change will upend our lives. In March 2022, Taiwan’s Ministry of Science and Technology warned that “human-induced global warming could disrupt both local ecosystems and the lives of Taiwanese.”
The ministry cited effects such as stronger typhoons, more severe droughts, intensive rain, flooding, reduction of rice harvests and wider spread of tropical diseases. Reports already paint a bleak picture of declining fishing stocks in Taiwan’s coastal waters. Already, the mackerel movements off the coast of Yilan are changing due to warming ocean waters, negatively affecting the livelihood of local fishing communities.
Heavy Cost of Inaction
The setting of predefined risks for assessment will affect data capture and have a bearing on test outcomes. Estimates of financial loss in various scenarios of emission trajectory will influence the popular perception of climate risks beyond the technical use by regulators to evaluate resiliency.
A June 2021 report by Greenpeace modelled the high-emission, worst-case scenario of business as usual. This scenario in which nothing is done to mitigate climate change is labelled by the UN Framework Convention on Climate Change (UNFCCC) as “Representative Concentration Pathway (RCP) 8.5.”
For this scenario, the report found that extreme sea-level rise and subsequent flooding for the city of Taipei in 2030 alone could bring close to USD 30 billion in financial loss. The results were based on an analysis of three datasets: flooded areas by extreme sea-level rise and coastal flooding caused by storm surges and high tides, population density and GDP.
While the Greenpeace report is not the same as a climate stress test, which is a robust and detailed assessment of resiliency in the event of a system shock, the two overlap where they provide monetary figures for the extent of potential loss resulting from climate change. These numbers offer a glimpse of Taiwan’s climate future and serve an important public advocacy function. The message is simple: inaction or insufficient early action has a heavy price tag.
“It is reassuring that Taiwan—facing severe climate impacts yet excluded from the UNFCCC—is finally requiring its banks to carry out climate stress tests. Perhaps the results will encourage these institutions to divest from fossil fuels and other polluting industries to avoid sabotaging their own future finances and the wellbeing of the planet,” says Sally Jensen, a climate reporter and educator currently based between the UK and Taiwan.
Conclusion: Eyes on the Data
With the exception of the United States, all G7 countries have conducted some form of climate scenario analysis or stress testing of climate-related extreme impacts. In January 2022, the European Central Bank (ECB) launched a round of climate stress tests to see how banks under its supervision would cope with climate-related shocks.
Recent results released by the ECB on 8 July 2022 showed that most of the 104 banks that participated in this round of testing operate without robust frameworks for understanding and assessing climate risks. Results also importantly revealed that an orderly green transition would lead to lower financial losses than a transition that is disorderly or in the absence of any policy action on climate.
Compared to other developed economies in the Asia-Pacific, Taiwan is a tad late to the scene of climate change and financial risks. Japan had already done a pilot climate scenario analysis in 2021, while South Korea will conduct its first climate stress test in December 2022. Taiwan will follow suit with climate stress testing in early 2023.
It is important that Taiwan begins to conduct climate stress tests without delay to the anticipated 2023 timetable. This is because climate stress tests are essential learning tools. They allow financial institutions to begin to gather data, compile their risk profile and fully grasp their vulnerabilities to climate change.
With each round of testing, financial regulators can improve their data collection and analysis. These increments of knowledge gained can bring in, over time, improved climate-related risk management and supervision. Moreover, they can mobilize green investment to transform the domestic economy into a more sustainable model.
Without a doubt, climate change poses difficult challenges ahead for Taiwan and other Pacific islands. It is an existential challenge for small islands on the frontline of a rising sea. The challenge calls for us to follow the science and understand the various pathways that could be brought into being by our collective resolve.
Climate stress tests offer a glimpse of our future. We cannot afford to look away.
