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Principle 7 – Scenario analysis of climate-related financial risks

7.Where appropriate, relevant financial firms should develop and implement climate-related scenario analysis frameworks, including stress testing, in a manner commensurate with their size, complexity, risk profile and nature of activities.
 
7.1Relevant financial firms should build sufficient capacity and expertise to develop and implement climate-related scenario analysis and stress testing programmes suited to their size, complexity, risk profile and nature of activities. These frameworks should include clearly defined objectives that reflect the firm’s overall climate-related financial risk management strategies and objectives. While working to build adequate internal capabilities in climate scenario development and analysis, financial firms may utilise relevant existing or emerging climate scenarios, whether global or regional, general or purpose-built.
 
7.2The objectives of scenario analysis could include, for example, exploring the impacts of climate-related financial risks on the financial firm’s strategy and business model, identifying and measuring vulnerabilities to relevant climate-related financial risk factors including physical and transition risks, and estimating climate-related exposures and potential losses across a range of plausible scenarios.
 
7.3Financial firms should identify appropriate data inputs and suitable metrics to assess climate-related financial risks.
 
7.4Scenarios should include a spectrum of plausible, relevant and severe climate pathways, and should cover the types of climate-related financial risks (physical, transition and/or liability risks) to which financial firms are exposed and that affect their businesses and risk profiles.
 
7.5Financial firms should conduct scenario analysis over a range of time horizons and assumptions while considering the benefits and limitations of such assumptions and the models. Short-term analysis is typically used to assess the impact on the firm’s risk profile and business operations, while longer-term analysis facilitates assessment of business models in light of shifts in economic and financial system structures.
 
7.6Financial firms should use the results of scenario analysis as an input to analysing the adequacy of their existing risk management framework, including designing and implementing actions that mitigate the impact of identified climate-related financial risks. Results of the stress tests should also be considered as part of the internal capital and liquidity adequacy assessment processes, as detailed under Principle 6.
 
7.7Climate-related financial risk scenario analysis is a developing area and approaches are expected to evolve and mature over time. Nevertheless, a climate-related scenario analysis framework could, in the near term, assist financial firms in identifying data and methodological limitations and uncertainties in climate-related financial risk management, as well as helping inform the firm about the adequacy of its climate-related financial risk management framework.