Through the Looking Glass: How COVID-19 Revealed the Need for Climate Stress Testing

What is the importance of climate stress testing as an institutional investor/business owner?

During COVID-19, small businesses and corporate firms alike were forced to internalize the financial downturns of the pandemic, with mass employee layoffs and lower product demand. In the US alone, real GDP fell 9% below its pre-pandemic level; this intense dip reflected the country’s lack of preparation, as governors, businesses and public had little expertise to navigate COVID-19. As economies are still recovering from this season, this pandemic uncovered the power of stress testing, a tool we must utilize to avoid similar pitfalls when climate change inevitably devalues our natural capital.  

Why This Matters 

• Institutional Risk Mitigation: If global warming temperatures reach 4°C, losses from climate change will exceed $23 trillion over the next 80 years. Without necessary climate stress testing, institutional investors, if stagnant, will suffer in the form of asset decline. 

• Cheaper Today: Internalizing stress tests today, although costly, will avoid long-term effects of loss of capital due to climate change, which is far costlier.  

• Millennial/Gen Z Appeal: In a study conducted by Deloitte, 79% of Gen Zs and 81% of millennials believe that businesses should be held responsible for integration of sustainable practices. Younger generations prioritize eco-conscious companies more now than ever, driving the case for ESG incorporation, including climate stress testing. 

  

  UNEP Finance Initiative’s Comprehensive Good Practice Guide to Climate Stress Testing. 

What are Climate Risk Stress Tests? 

Focused on long-term value creation, these stress tests utilize scenario analysis to predict potential impact of climate change. By engaging in this thought experiment, firms will uncover the interrelationships between climate risks, financial shocks, infrasectoral affects and total company impact. This mobilizes an institution’s understanding of their material climate risks, identifying key vulnerabilities and thus opportunities for improved operational stability.  

COVID-19 as a Textbook Case 

COVID-19 demonstrated the economic sensitivity of our countries, highlighting the implications of an absence of pandemic stress testing. Governments worldwide were ill-prepared to resolve pandemic-elicited effects due to a lack of time, not to resources or manpower. Institutions and companies have a chance to do it right: to avoid another loss of trillions of assets, considering the materiality of global warming in relation to natural resources. Companies are fortunate in their current standings, equipped with the knowledge and time to mitigate the devasting effects of climate change via stress testing.  

Action Items 

• Institutional Investors: Conduct portfolio analysis, screening for assets that may be affected by climate risks. Consider assumptions in relation to key climate and economic drivers, with the purpose of discovering potential economic and infrastructure risks, streamlining findings into implementable mitigation strategies. 

• Corporate Firms/Small Businesses: Administer a climate stress test independently or through the providence of an external party. Responsible Alpha, along with other environmental consulting companies, can assist in the realm of climate risk modeling.