Which risks should the test capture?
Published: 25 January 2023
It is difficult to capture all climate risks, both physical risks and transition risks, in a single stress test. Consequently, one risk area needs to be selected and the stress test designed accordingly. In order to assess the magnitude of climate-related financial risks, it is necessary to evaluate the impact of different risks on different sectors, the exposure of the financial system to these sectors and the expected policy responses.
Physical risks are currently considered less important for financial stability
The drought and forest fires in the summer of 2018 gave a taste of how Sweden could be affected by a warmer climate. Despite extensive physical damage to forests and land, the macroeconomic effects and impact on the financial sector were relatively marginal.See Riksbank (2018) Article - Small effects on production and inflation of the summer’s drought and forest fires, Monetary Policy Report. This can be interpreted as indicating that the risks to financial stability from individual hot summers will be relatively small in the coming years. However, the risk of extreme precipitation and forest fires can be expected to increase in the future. See, for example, Swedish Civil Contingencies Agency (2020) Risker i ett klimatanpassat Sverige, preliminary study (Risks in a climate-adapted Sweden - Swedish only).
In 2020, the Riksbank conducted a study on the proportion of Swedish homes at risk of flooding if sea levels rise. See M. Danielsson (2020), Rising sea levels due to global warming will entail increased risks for housing, Economic Commentary, no. 10, Sveriges Riksbank. An increased risk of flooding could have a major impact on individual households and could lead to some real estate and other property becoming uninsurable. However, the study concluded that the financial risks associated with future flooding were considered low.
For physical risks to have a significant impact on financial stability in the coming years, a large number of extreme weather events would likely need to occur in Sweden in a short period of time. Such a scenario should not be ruled out, but can be considered less likely in the near term. See, for example: Skogsbruksåtgärder och skador på samhällsfunktioner (skogsstyrelsen.se) (Forestry measures and damage to social functions - Swedish only). For the time being, physical risks are thereby deemed to have relatively small implications for financial stability, although the consequences for individual actors could be severe.
Transition risks are deemed to be of greater importance for financial stability in the near term
The need to reduce carbon emissions affects companies in all sectors. Industries with large direct emissions, such as agriculture, transport and the energy sector, need to reorganise their operations to reduce emissions. Industries with high indirect emissions, such as real estate and textiles, are instead affected, among other things, by the need for high-emitting subcontractors to restructure their operations. In practice, transition risks therefore affect the entire Swedish economy.
Taking into account the risks associated with climate change, this is likely to lead to a higher probability of loan losses for the financial institutions that lend money to the companies. Lending to Swedish non-financial corporations amounts to just under SEK 3,000 billion, which corresponds to about 30 per cent of lending (excluding lending to financial institutions) in Sweden. See Statistics Sweden Financial Market Statistics (September 2022). This means that a large part of the banks’ lending is directly exposed to companies’ transition risks, although firms in some sectors are more at risk than those in other sectors.
Households will also be affected by the transition. As sustainable energy sources are expanded and fossil energy sources are phased out, energy prices may become high and volatile, with negative consequences for household finances. This may also increase credit risk for the banks, as a large share of Swedish bank lending is to households. See Statistics Sweden Financial Market Statistics (September 2022).
From a Swedish perspective, transition risks are deemed to have a greater impact on the financial sector and thus on financial stability than physical risks, and therefore the Riksbank’s intended stress tests will focus on assessing this type of risk.