Insights from the CFRF’s Scenario Analysis Guide for Banks

It outlines current industry practices and can serve as a manual for firms that wish to enhance their scenario analysis capabilities. The guide is part of the CFRF’s third round of guides to help the financial sector develop its approach to addressing climate-related financial risks and opportunities.

The guide covers four topics and each of them is supported by case studies. The below takeaways are a snapshot of what the guide offers. Banks are advised to consider the full document.

Key takeaways from the guide

Section 1: Climate scenario selection

• Scenario analysis enables banks to test the resilience of their strategy to different climate pathways and define their risk appetite at a client and portfolio level.
• There are multiple use cases for climate scenario analysis in the guide and banks, especially those with limited resources, should prioritise the ones that are most material and urgent, applying a proportionality principle.
• Scenario selection is complex. Banks should have working criteria lists for scenario selection. These could include considerations of scenario time horizon, coverage, purpose of the analysis, granularity of scenario variables, and evaluation of assumptions and limitations.
• Banks that do not have internal climate scenario design capabilities should consider using or adapting existing public scenario families, such as scenarios published by international and governmental bodies (IEA, NGFS, IPCC, CCC, DDPP, UNEPFI-NIESR), or scenarios published by central banks and regulators (PRA CBES 2021, ECB 2022 CST).

Section 2: Sensitivity analysis and climate scenarios

• Robust climate risk analysis involves both climate scenario analysis and sensitivity analysis. The main difference between the two is that the former helps assess the impact of a change in multiple input variables on the dependent variable, while the latter explores how one independent variable (e.g., carbon price change) affects the dependent variable (e.g., credit portfolio) under specific conditions.
• Sensitivity analysis adds credibility to scenario analysis as it helps evaluate how stable the analytical conclusions are to a wider range of possible inputs.
• When performed as a standalone activity, sensitivity analysis requires fewer modelling resources than scenario analysis.
• The key limitation of performing sensitivity analysis in isolation is that it does not capture non-linearities between multiple variables and can lead to simplistic or even misleading conclusions. The remedy is to combine it with scenario analysis.
• Examples of sensitivity analysis use include:
  • to prioritise vulnerabilities in the portfolio for further analysis,
  • to confirm the credibility of certain models underpinning scenario analysis, or
  • to communicate thresholds.

Section 3: Scenario analysis for physical risk and climate adaptation

• Adaptation planning is the process of evaluating risks and prioritising approaches to manage or minimise the consequences of climate change on the entity in question. Considering climate change adaptation plans enhances the value of climate scenario analysis.
• Banks should consider creating their own adaptation plans and understanding what their clients’ and customers’ adaptation plans are. Inclusion of adaptation plans can potentially reduce the level of adversity in a climate scenario.
• When exploring their clients’ and customers’ adaptation plans, banks should consider different impact mechanisms that elevate traditional risks, such as credit, market, operational or reputational risks.
• Banks should evaluate the credibility of the clients’ and customers’ adaptation plans. The CFRF shares a high-level list of evaluation criteria to be considered by banks.

Section 4: Embedding climate scenario analysis in decision making

• Banks can use the outputs of climate scenario analysis in several ways, ranging from managing climate-related risks to identifying opportunities, and informing business strategies.
• Climate scenario analysis can inform multiple business processes within a bank. Their results can be used to feed, enhance, and adapt processes around: client selection, onboarding and lifecycle management, credit analysis and application, credit authorities and approval, expected credit loss/ impairment calculation, risk modelling and quantification, pricing, product propositions and approval, climate ambition setting and external commitments, regulatory stress tests, internal stress tests and sensitivity analysis, reverse stress test, risk reporting, single name and portfolio level risk appetite, ICAAP, ILAAP, non-financial disclosures, macroeconomic forecast and corporate and financial planning, business continuity planning and location strategy, third parties and sourcing process.

Further remarks

Scenario analysis is an essential tool for building some understanding of how climate-related risks may impact business planning, strategies and financial performance of banks and other financial institutions. It also helps identify opportunities and drive future business growth. Banks are advised to enhance their climate-related and environmental financial risk management and modelling capabilities to both comply with regulatory developments and stay in line with the industry’s best practice.