Managing climate risks: UKEF’s portfolio stress testing experience and the Net-Zero transition

UK Export Finance (UKEF) has been actively working on assessing climate-related risks in its portfolio. This article examines the development of a climate portfolio stress test model which uses bespoke scenarios to analyse potential financial losses arising from climate-related physical and transition risks.

Climate risks challenge financial sector to find new approaches to risk management

An important function of the financial sector is to correctly allocate capital on a portfolio level and to ensure that investment portfolios are resilient against different risks and adequate for the organisation’s risk tolerance.

Climate risk is a recognised anthropogenic material risk which has already led to widespread adverse impacts and related costs and losses.^[1] Climate change is expected to further disrupt economic activities, damage assets, and negatively affect corporates and fiscal stability.^[2],[3] To mitigate climate change and limit resulting physical climate risks, most sovereigns are implementing decarbonisation transition policies across different economic sectors.^[4] These policies are envisaged to significantly influence sovereign fiscal stability and corporate profitability – negatively and positively.^[5],[6],[7]

Unlike many known and already well-managed risks that are underpinned by historic data, climate risk is considered a green swan event: we know it is going to happen, we just do not know exactly when and how.^[8] The non-linear nature of climate risk requires new approaches to risk management, which prompted the G20 members to establish the Task Force on Climate-Related Financial Disclosures (TCFD) in 2015.^[9] TCFD has become part of the International Financial Reporting Standards (IFRS),^[10] prudential frameworks,^[11] and regulation.^[12] Further advancements in climate risk management are to be expected, based on supervisory requirements and feedback,^[13] opinion pieces,^[14] and stated intentions of financiers to eventually develop climate-related impairments, climate risk appetite limits, climate informed pricing for deals etc., much of which is still work in progress.

UKEF is committed to considering the influence of climate change on its portfolio and financing projects aligned with the transition to Net-Zero.^[15] UKEF is a member of the Net-Zero Export Credit Agencies Alliance^[16] and part of the Berne Union’s Climate Working Group.^[17] In addition, UKEF was the first central government entity in the UK to implement TCFD recommendations. UKEF’s Climate and ESG Risk team (the Team) is responsible for transaction-based climate risk management and climate stress testing UKEF’s portfolio.

Climate stress testing ensures that UKEF’s portfolio is resilient against climate risks and adequate for the organisation’s risk tolerance. It also provides valuable information to further improve related internal controls and processes and contributes to UKEF’s mission statement.

UKEF’s in-house climate stress-test model

UKEF’s climate stress-test model is scorecard-based and is regularly updated and developed. The scorecard approach helps in addressing data and methodological uncertainties, offering a clearer view of the drivers behind changes in credit risk. This is particularly important due to the diverse geographic and sectoral composition of UKEF’s portfolio.

The Model employs scenarios from energy and climate models released by the Network for Greening the Financial System (NGFS),^[18] World Resource Institute (WRI),^[19] and Coupled Model Intercomparison (CMIP)^[20] to project physical and transition risk scores for five scenarios^[21] and five-year time intervals up to 2050. The Model can be used for assessing climate-related financial risk and opportunities, for sovereigns and sectors, in different regions.

The sovereign component of the model covers all countries, projecting physical (Figure 1.a) and transition risks (Figure 1.b) and translating these into credit impacts for climate stress testing. Physical risks include the impacts of floods, heatwaves, wildfires, crop failures, droughts, and water stress on countries' economic, social, and demographic structures. Transition risks cover factors such as economic growth, fossil fuel export revenue, the fiscal impact of carbon taxes, access to renewable energy, and energy prices. The model assigns different weights to these components based on literature, financial institutions’ previous work, and expert opinions.

The sector component focuses on how the transition to Net-Zero could impact 15 economic segments across 14 regions. It quantifies the effects of changes in sectoral gross value added, carbon taxation, energy prices, and carbon footprints on credit risk across different scenarios and timeframes. The model can compare how climate transition risks vary by region for specific sectors (Figure 2.a) and examine how regional characteristics influence sectoral transition performance (Figure 2.b).

One of the key challenges in climate stress testing is converting climate risk scores into credit risk ratings. The unprecedented and non-linear nature of climate risks, coupled with the lack of historic data, makes it difficult to apply traditional validation techniques. For instance, the frequency and magnitude of the projected climate physical risks are unprecedented. Concurrently, we observe unprecedented technological transformations and economies transitioning towards Net-Zero or decreasing their greenhouse gas emissions. Such a novel and complex reality challenges the use of validation methods based on applying the Model to project past credit ratings. Conscious of these challenges, UKEF’s Climate and ESG Risk team continues to collaborate with financial consultancies, government departments, the Bank of England, the Office for Budget Responsibility (OBR), the Global Association of Risk Professionals (GARP), and academic institutions to improve the model.

High level results and insights from the Model

Having already used the Model for several portfolio stress test exercises, we have identified common patterns among the results. We have observed that climate physical risks are the main drivers of changes in credit ratings for scenarios that assumed lower progress in decarbonisation. Our Model suggests that more frequent heatwaves and higher temperature would have a larger negative impact on credit quality for hotter weather countries. One driver for this are losses in labour productivity as a consequence of extreme heat. Crop failure and drought would lead to downgrades in the case of agriculture-based economies, which are likely to already have a low credit rating. These trends align with previous works developed by the European Investment Bank,^[22] for country risk scores, the Bank of England^[23], and the Notre Dame University’s ND-GAINS indices.^[24]

In scenarios where decarbonisation efforts are stronger, the transition to Net-Zero is projected to negatively impact economies heavily reliant on fossil fuel exports or fossil fuel-dependent energy systems. However, some countries could see an improvement in their credit risk due to the availability of renewable or low-carbon energy.

The sectoral component of the Model projects that highly carbon intensive industries (such as aviation; steel; cement and chemical manufacturing; oil and gas production; and conventional power generation) would see downgrades in their credit ratings as a result of climate stress testing, especially when considering scenarios in which Net-Zero targets are being met. Regional differences may arise due to diverse fuel baskets and carbon pricing policies. Conversely, sectors such as renewable energy and electromobility, within those scenarios, are projected to experience enhancements in their creditworthiness within these scenarios. Recent work^[25] published by the European Central Bank confirms that firms with higher carbon emissions and unclear transition plans are currently experiencing higher interest rates for bank lending. This demonstrates that banks are already considering climate transition risks for pricing.

Only the beginning: early lessons and future work

Robust governance and peer review have been critical in the development and refinement of UKEF’s in-house climate stress test model. The Team has established procedures to cross-check data input and processing to ensure accuracy, and regular benchmarking exercises are conducted to compare the model's outputs with those of other financial and academic institutions. Any updates to the model are discussed and approved by a dedicated Technical Advisory Group, consisting of colleagues from different risk-related divisions and levels of seniority.

UKEF is committed to further improving the model and is closely monitoring best practices in climate stress testing within the financial sector. Discussions are ongoing about developing climate risk appetite limits, modelling climate-related impairments, and pricing climate risk in credit ratings for new deals—much of which is still in progress.

The Team looks forward to continuing collaboration with other institutions to share experiences, lessons learned, and insights on improving and standardising methodologies for climate financial risk assessments. As global temperatures rise and mitigation efforts accelerate, climate risk management is becoming an increasingly important part of financial portfolio management and responsible capital allocation.

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2. https://www.bankofengland.co.uk/quarterly-bulletin/2024/2024/measuring-climate-related-financial-risks-using-scenario-analysis ↑
3. https://www.econ.cam.ac.uk/research-files/repec/cam/pdf/cwpe2127.pdf ↑
4. https://www.ipcc.ch/report/ar6/wg3/downloads/report/IPCC_AR6_WGIII_FullReport.pdf ↑
5. https://www.bankofcanada.ca/wp-content/uploads/2021/11/BoC-OSFI-Using-Scenario-Analysis-to-Assess-Climate-Transition-Risk.pdf ↑
6. https://obr.uk/frs/fiscal-risks-and-sustainability-july-2023/#chapter-3 ↑
7. https://www.bankofengland.co.uk/stress-testing/2022/results-of-the-2021-climate-biennial-exploratory-scenario ↑
8. https://www.bis.org/publ/othp31.pdf ↑
9. https://www.fsb-tcfd.org/about/ ↑
10. https://www.ifrs.org/issued-standards/ifrs-sustainability-standards-navigator/ifrs-s2-climate-related-disclosures/ ↑
11. https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/supervisory-statement/2019/ss319 ↑
12. https://www.legislation.gov.uk/uksi/2022/31/made ↑
13. https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/letter/2022/october/managing-climate-related-financial-risks.pdf ↑
14. https://www.kcl.ac.uk/business/assets/pdf/research-papers/accelerating-transition.pdf?trk=public_post_comment-text ↑
15. https://www.gov.uk/government/publications/uk-export-finance-sustainability-strategy-2024-29/uk-export-finance-sustainability-strategy-2024-29 ↑
16. https://www.gov.uk/government/news/ukef-joins-new-international-alliance-to-help-export-finance-reach-net-zero ↑
17. https://www.berneunion.org/Stub/Display/234 ↑
18. https://www.ngfs.net/en/ngfs-climate-scenarios-phase-iv-november-2023 ↑
19. https://www.wri.org/applications/aqueduct/water-risk-atlas/#/?advanced=false&basemap=hydro&indicator=w_awr_def_tot_cat&lat=30&lng=-80&mapMode=view&month=1&opacity=0.5&ponderation=DEF&predefined=false&projection=absolute&scenario=optimistic&scope=baseline&threshold&timeScale=annual&year=baseline&zoom=3 ↑
20. https://wcrp-cmip.org/cmip7/ ↑
21. UKEF climate stress test model presents credit ratings associated with 5 NGFS scenarios, namely: Current Policies, Net-Zero, Delayed Transition, Fragmented World, and Low Demand. ↑
22. https://www.eib.org/attachments/efs/economics_working_paper_2021_03_en.pdf ↑
23. https://www.bankofengland.co.uk/quarterly-bulletin/2024/2024/measuring-climate-related-financial-risks-using-scenario-analysis?utm_source=Bank+of+England+updates&utm_campaign=9e2b83adff-EMAIL_CAMPAIGN_2024_04_17_11_31&utm_medium=email&utm_term=0_-9e2b83adff-%5BLIST_EMAIL_ID%5D ↑
24. https://gain.nd.edu/our-work/country-index/ ↑
25. https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp29690f4c56a156.en.pdf?b6e005d7334de68ad976f24bd9ae5759 ↑