Brazil makes strides on climate-related financial risks

Climate stress tests show increasing exposure to physical risks in credit portfolio

The Banco Central do Brasil has taken important measures to assess and mitigate climate-related risks to the financial system of the country. Brazil, which is heavily dependent on natural resources and has large agricultural and forestry sectors, is especially vulnerable to the threat of climate change.

At a roundtable hosted by OMFIF’s Sustainability Policy Institute, representatives from the BCB spoke about the bank’s climate risk evaluation exercise, the challenges associated with it and the next steps to better integrate climate risk management frameworks into the financial sector.

The discussion focused mainly on the climate stress test, the results of which were published in the BCB’s Financial Stability Report. The test analysed the sensitivity of the credit portfolio to physical climate risks, specifically extreme drought. The BCB used information from a platform run by the Ministry of Science and Technology, which consolidates meteorological projections and estimations of the impact of climate risk on a range of social, humanitarian and economic factors.

The platform captures information at the municipality level. This was combined with statistics from the BCB’s credit bureau, which collects borrowing information at the same level. Using information from the two sources, the BCB was able to estimate the sensitivity of the credit portfolio to drought for all 5,600 municipalities in the country.

The stress test analysed sensitivity at three points: 2020, 2030 and 2050. In the current scenario., 16% of system loans are exposed to drought risk, with the southeastern part of the country being the most affected. The exposure increases to 19% in 2030 and 20% in 2050, and the geographic impact remains concentrated in the southern region.

The BCB also conducted a separate study at the industry level on the exposure of the financial sector’s credit portfolio to transition risks through sector-based emissions mapping. The results show that 8% of the portfolio is exposed to these risks. The bank’s representatives at the roundtable noted that, while the impact of the risk was not severe, it is important for the BCB to be prepared and continue conducting these analyses with different physical risks such as floods and general weather pattern changes.

Climate stress tests reinforce the need for financial institutions to take climate change seriously and to integrate climate risk management into their decision-making processes. Failure to do so could lead to significant financial losses in the future as the impacts of climate change continue to intensify. However, representatives from the BCB acknowledged that conducting this analysis is not straightforward and knowledge gaps persist.

They identified two key issues. The first is understanding the implication of a longer time horizon associated with climate-related risks. Unlike traditional stress test scenarios which are sudden, unexpected and intense, climate risks are prevalent over time and have a more enduring impact. This makes it difficult to control for technological advances and to isolate the exact impact of the risk on the economy. The second issue is the availability of quality, comparable and transparent data.

The BCB was able to reduce the uncertainty regarding time horizons by using indicators and information from other domestic agencies which had already calculated the economic losses associated with extreme drought. The database collected data at the municipality level, which allowed for a granular study of the sensitivity of the credit portfolio to extreme drought in each municipality.

The granularity was the key reason the BCB used the domestic platform as opposed to the Network for Greening the Financial System’s guidelines, despite being on the steering group. The representatives noted that there is an effort globally to produce guidelines for central banks to conduct climate tests which can be compared across countries and over time, and to work to make data more standardised and comparable.

The BCB has included sustainability on its agenda at the same level as other macroeconomic issues, which is a positive signal to the financial system in the country. In addition to the stress tests, the BCB is developing and implementing other policies to safeguard the financial system against climate-related risks. A series of regulations have been established to ensure banks disclose information pertaining to environmental and social risks within their broader risk assessments. These disclosures are to be in line with the Task Force for Climate-related Financial Disclosures’ requirements to allow investors and the central bank to follow how financial institutions are preparing for climate change.

The BCB’s measures to address climate risk are a crucial step towards promoting financial stability in the face of climate change. The representatives reiterated that the BCB’s core mandate is ensuring financial stability in the country, and it is the government who is responsible for setting the tone for policy responses to climate-related risks. Going forward, it will be important for all institutions to continue to build on these efforts and collaborate with stakeholders to develop effective strategies for managing climate-related risks.

Arunima Sharan is Senior Research Analyst at OMFIF.

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