Are Financial Institutions Ready to Link Climate Stress Testing with Credit Risk, IFRS 9, and Pricing?

Climate stress testing has moved from a supervisory pilot to a strategic instrument for capital allocation. Regulators now expect banks to quantify the impact of transition pathways on the probability of default, loss given default, and portfolio concentration risk. Investors expect the same discipline. The next frontier requires banks to translate macroeconomic transition scenarios into loan-level risk metrics and pricing decisions that withstand scrutiny under International Financial Reporting Standards (IFRS) 9, capital adequacy, and disclosure regimes.

This shift defines Climate Stress Testing 2.0. It integrates climate scenario analysis, credit analytics, and pricing governance into a unified framework that connects long-term transition risk to present-day underwriting and portfolio management.

Regulatory Convergence Is Setting the Baseline

Supervisory expectations now anchor climate risk in prudential frameworks. The European Central Bank has required banks under its supervision to integrate climate and environmental risks into governance, strategy, and risk management. In its 2022 climate stress test, the ECB assessed 41 significant institutions and found that most banks lacked granular data and modelling capabilities to quantify climate risks at the counterparty level. The exercise covered transition and physical risk scenarios over 30 years and reinforced supervisory expectations for integration into ICAAP and credit processes.

In the United Kingdom, the Bank of England conducted the 2021 Climate Biennial Exploratory Scenario. The results showed that while UK banks would remain above minimum capital requirements under the modelled scenarios, expected losses could rise materially in sectors such as energy, transportation, and real estate under late and disorderly transition pathways. The Bank emphasised the need for firms to improve counterparty-level emissions data and to translate scenarios into credit risk.

In the United States, the Federal Reserve launched its pilot climate scenario analysis in 2023 with six large banks. The exercise focused on transition and physical risks across corporate and real estate portfolios, with results highlighting significant modelling heterogeneity and data challenges. The Fed framed the pilot as a learning exercise but signalled that scenario analysis will inform supervisory expectations.

Across jurisdictions, supervisors converge on three priorities: granular data, forward-looking scenario analysis, and integration into core risk processes. Climate Stress Testing 2.0 operationalises these priorities at the loan level.

From Macro Scenarios to Counterparty-Level Metrics

Scenario design has matured. The Network for Greening the Financial System (NGFS) provides reference transition pathways, including orderly, disorderly, and hot-house world scenarios. These scenarios incorporate carbon-pricing trajectories, energy-mix shifts, and sectoral output changes over multi-decade horizons. Many regulators reference NGFS scenarios as a common baseline.

However, translating NGFS outputs into loan-level risk requires more than overlay adjustments. Banks must map sectoral shocks to borrower cash flows, asset valuations, and refinancing capacity. This involves integrating carbon-pricing assumptions, energy-demand projections, and policy timelines into borrower-specific financial models. Several leading global banks have disclosed structured and measurable approaches to integrating climate risk into core credit strategy.

HSBC, one of the world’s largest banking and financial services organisations with operations across Europe, Asia, and the Americas, reports that it uses climate scenario analysis aligned with NGFS pathways to assess portfolio resilience and inform risk appetite and sector strategy.

ING Group, a Netherlands-based international bank with a strong European corporate lending franchise, applies its Terra approach to steer lending portfolios toward alignment with the goals of the Paris Agreement, using sector-specific decarbonisation pathways to guide exposure management.

BBVA, a Spain-headquartered global banking group with significant operations in Europe and Latin America, integrates climate risk metrics into its risk management framework and discloses sector-level exposure sensitivity under different transition scenarios.

These disclosures show progress at the portfolio level. Climate Stress Testing 2.0 extends the methodology to individual obligors. Banks increasingly combine borrower emissions data, energy intensity metrics, and capital expenditure plans with scenario-specific carbon price assumptions to estimate impacts on EBITDA, leverage, and debt service coverage ratios. This enables recalibration of the probability of default under IFRS 9 and internal rating systems.

Linking Climate Risk to Pricing and Capital Allocation

Risk quantification alone does not change outcomes. Pricing and capital allocation must reflect the forward-looking risk profile.

Under IFRS 9, banks must incorporate forward-looking information into expected credit loss calculations. Transition scenarios that materially affect borrower cash flows can influence staging decisions and lifetime loss estimates. Institutions that systematically embed climate-adjusted probability of default and loss-given-default into expected credit loss models align accounting outcomes with supervisory expectations.

Capital frameworks reinforce this link. The Basel Committee on Banking Supervision published principles for the effective management and supervision of climate-related financial risks in 2022. The Committee expects banks to consider climate risk drivers in credit, market, and operational risk assessments, and to integrate them into their internal capital adequacy assessment processes. This creates a direct connection between climate scenario outputs and economic capital allocation.

Market leaders have begun to reflect transition risk in lending terms. BNP Paribas has reduced financing exposure to coal-related activities and committed to aligning its credit portfolio with net zero by 2050. Standard Chartered discloses financed emissions and sector-specific transition plans, linking client engagement with portfolio steering. These policies influence sectoral pricing, tenor decisions, and client selection.

At the growth end of the market, climate-focused lenders such as Aspiration have built business models around directing capital toward low-carbon assets and transparent impact reporting. While smaller in balance sheet terms, such institutions demonstrate how climate metrics can shape underwriting and product design from inception.

Across models, the direction is clear. Loan-level climate analytics inform risk-based pricing, portfolio limits, and capital allocation decisions in a coherent framework.

Data Architecture and Model Governance

Advanced climate stress testing requires robust data governance. Emissions data quality remains uneven, particularly for Scope 3 emissions. The International Sustainability Standards Board has issued IFRS S1 and IFRS S2 standards to establish consistent sustainability-related disclosure requirements, including climate-related metrics aligned with the recommendations of the Task Force on Climate-related Financial Disclosures. As these standards gain adoption, counterparty data reliability should improve.

Banks must integrate external climate data providers, internal credit systems, and scenario engines into a unified architecture. Model risk management functions need to validate assumptions on carbon prices, technological adoption rates, and sector elasticities: transparent documentation and sensitivity analysis support supervisory dialogue and audit requirements.

Institutions that treat climate stress testing as a periodic regulatory exercise struggle to achieve this integration. Those that embed climate variables into core credit systems create a continuous feedback loop between scenario analysis, underwriting, monitoring, and pricing.

Portfolio Steering and Strategic Positioning

Climate Stress Testing 2.0 supports strategic portfolio steering. Transition scenarios reveal concentration risk in carbon-intensive sectors, refinancing cliffs under rising carbon prices, and asset stranding risk in real estate and energy portfolios. By quantifying these exposures at the loan level, banks can adjust sector limits, revise risk appetite statements, and engage clients on transition plans with analytical backing.

The European Banking Authority has integrated ESG risks into its supervisory review and evaluation process, reinforcing the expectation that banks incorporate environmental risk into strategy and governance. Alignment between board-level climate commitments and granular credit analytics strengthens credibility with supervisors and investors.

This alignment also informs product innovation. Sustainability-linked loans and transition finance instruments require credible key performance indicators and pricing adjustments tied to measurable outcomes. Loan-level climate analytics provide the evidence base for setting targets and verifying performance.

A Defining Capability for the Next Decade

Climate risk now sits at the intersection of prudential supervision, accounting standards, investor expectations, and client transition strategies. Institutions that connect NGFS-aligned transition scenarios to counterparty-level financial models, IFRS 9 provisioning, and risk-based pricing create a coherent decision-making framework.

Climate Stress Testing 2.0 represents a structural upgrade in risk management capability. It enhances transparency, supports disciplined capital allocation, and positions banks to finance the transition with analytical discipline. In an environment where regulators, investors, and clients demand measurable progress, this capability defines competitive advantage in climate risk management and sustainable finance.