Overview of the Pilot CSA Exercise
Large banking organizations and the broader financial system are exposed to climate change through macroeconomic and microeconomic transmission channels associated with physical and transition risk drivers. Physical risks refer to the harm to people and property arising from acute, climate-related events, such as hurricanes, wildfires, floods, heatwaves, and droughts as well as longer-term chronic phenomena, such as higher average temperatures, changes in precipitation patterns, sea level rise, and ocean acidification. Transition risks refer to stresses to certain institutions, sectors, or regions arising from the shifts in policy, consumer and business sentiment, or technologies associated with the changes that would be part of a transition to a lower carbon economy.
Figure 1 describes the transmission channels through which climate-related risk drivers could impact large banking organizations. Physical and transition risk drivers associated with climate change may affect households, communities, businesses, and governments through damages to property, shifts in business activity, or changes in the values of assets and liabilities. These effects could manifest as traditional prudential risks to large banking organizations, including credit, market, operational, and liquidity risk.
Figure 1. Climate risk drivers manifest as prudential risks
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Note: Examples are indicative and not exhaustive.
Source: Participant Instructions.
Pilot CSA Exercise Objectives
The 2023 pilot CSA exercise had two primary objectives:
- To learn about large banking organizations' climate risk-management practices and challenges; and
- To enhance the ability of large banking organizations and supervisors to identify, estimate, monitor, and manage climate-related financial risks.
The pilot CSA exercise comprised a physical risk module and a transition risk module. Each module described forward-looking risk scenarios, including core climate, economic, and financial variables, where appropriate. The scenarios selected for the pilot CSA exercise were neither forecasts nor policy prescriptions. They did not necessarily represent the most likely future outcomes or a comprehensive set of possible outcomes. Rather, they were chosen to represent a range of plausible future outcomes that could help build understanding of how certain climate-related financial risks could manifest for large banking organizations and how these risks may differ from the past.
Each participant estimated the effect of these scenarios on a relevant subset of credit exposures. The physical risk module focused on estimating the effect of common and idiosyncratic shocks of varying levels of severity on residential real estate (RRE) and commercial real estate (CRE) loan portfolios over a one-year horizon in 2023. The Federal Reserve set broad parameters around the severity of physical hazards by selecting a future point in time on specific Shared Socioeconomic Pathways (SSPs) or Representative Concentration Pathways (RCPs) presented by the Intergovernmental Panel on Climate Change and a specific return period loss.2 The transition risk module focused on estimating the effect of different transition pathways, as described by the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), on corporate and CRE loan portfolios over a 10-year horizon from 2023-32. Participants assumed that balance sheets remained static over the relevant projection horizon.
The Federal Reserve collected qualitative and quantitative information from the six participants and engaged with the participants throughout the exercise to understand the data and methodological challenges that they faced in measuring and managing the financial risks of climate change.
Table 1 summarizes the general design elements, while table 2 provides additional detail for the physical risk and transition risk modules.
Table 1. General design elements of the pilot CSA exercise
| Element | Description |
|---|---|
| Risk drivers | Physical risks and transition risks modeled independently in separate modules |
| Estimation | Participants estimate loan-level estimates for select credit portfolios |
| Balance sheet assumption | Static |
| Key risk parameters | Probability of default and loss given default |
| Bank submissions | Data templates, supporting documentation, and responses to qualitative questions |
| As-of date | December 31, 2022 |
Source: Participant Instructions.
Table 2. Module-specific elements of the pilot CSA exercise
| Element | Physical risk module | Transition risk module |
|---|---|---|
| Scenarios | Range of severity of shocks | NGFS: Current Policies and Net Zero 2050 |
| Type of shock | Common hazard specified by the Federal Reserve Idiosyncratic hazard chosen by each participant |
|
| Projection horizon | 1 year: 2023 | 10 years: 2023–32 |
| Loan portfolios | Residential real estate Commercial real estate |
Corporate Commercial real estate |
| Potential mitigants | Insurance | Obligor transition capacity |
Source: Participant Instructions.
For more detailed information related to the design of the exercise, please see the Pilot Climate Scenario Analysis Exercise: Participant Instructions (Participant Instructions), available at https://www.federalreserve.gov/publications/files/csa-instructions-20230117.pdf.
References
2. For example, a 100-year return period loss is a loss that has a 1 percent chance (1 in 100 years) of being equaled or exceeded in a given year. Return to text