Results highlight need for institutions to use common assumptions, refine analysis of individual companies and enhance methodologies.
Japan’s Financial Services Agency (FSA) and the Bank of Japan (BOJ) have published the results of a pilot scenario analysis exercise on climate-related risks in its finance sector.
The exercise was conducted in cooperation with three major banks and three major non-life insurance groups, using scenarios published by the Network for Greening the Financial System (NGFS) as common scenarios.
In April, the FSA published a Japanese-language report for domestic financial institutions providing information and guidance on the use of the NGFS scenarios and data for assessing climate risk.
The scenario analysis exercise was conducted to understand the impacts of climate change on the financial system and financial institutions – with a focus on understanding data constraints, assessing the validity of analytical assumptions and methods, and identifying issues for future improvement.
The impacts of transition and physical risks (mainly acute risks by floods) were examined based on credit exposures as of 31 March 2021.
The results indicated that the banks’ estimated increase in annual credit costs due to climate risks was “considerably lower” than their average annual net income, and that the estimated credit cost increases were similar to those published by individual banks in their TCFD reports.
However, the report says “caution is warranted in the comparison” due to the differences in models and sectors covered. The results “should not be interpreted as a definitive assessment” of the impacts of climate-related risks, as the objective of the exercise was “not to provide a quantitative assessment” of climate-related risks.
The exercise revealed that the results significantly depend not only on banks’ analytical models and the selection of variables for the models, but also on additional assumptions made by each bank given the lack of information and data on future prospects.
The assumptions varied in how businesses and technologies in the specific sectors will evolve, whether and how clients’ business models will be transformed, to what extent clients will be required to finance in transforming their business, and to what extent increased carbon prices will be passed on to the selling prices.
To understand the issues in risk estimation and enhance risk management, individual banks will have to ensure more comparability by using common assumptions, the report says. Banks will also need to “refine their analysis of individual companies” to apply scenario analysis in engagement with clients and support them in addressing climate change.
Such refinements should include considerations of how structural changes in specific industries, and business transformation efforts driven by banks’ engagement, will impact individual companies.
To utilise scenario analysis in business strategy development and risk management, financial institutions need to further enhance their methodology, taking into account their risk profiles as well as international discussions and developments in practice.
Going forward, the FSA and BOJ will continue dialogue with financial institutions on methods and practical application of the scenario analysis, while also contributing towards improvements in the NGFS scenarios and international data initiatives.