Reserve Bank to ask whether New Zealand banks are able to cope with climate change in a 27-year scenario where the planet is 2° warmer

What will happen to New Zealand’s banks, and the wider financial system, if global policymakers fail to keep global warming below 2° celsius? 

That’s the question the Reserve Bank of New Zealand (RBNZ) will ask in its new climate stress test, Too Little, Too Late, which has been given to the five largest banks this week. 

It was developed in collaboration with the participating banks, which are expected to report back their results by the end of the year. 

The RBNZ undertakes stress tests, under its financial stability mandate, to assess how well retail banks could cope with hypothetical financial crises. 

This year, the central bank has opted to test a climate-related scenario in which the global temperature rises 2°c, carbon prices climb above US$300, and economic growth slows. 

It has been posed as a “hypothetical severe but plausible future scenario”. It is not a forecast or prediction of climate change and its impact on the economy.  

“Climate-related risks are already impacting the financial system and the broader New Zealand economy as witnessed by the cyclone and inland flooding affecting Auckland and other areas of the North Island in early 2023,” the RBNZ said in an overview of the test. 

“We think it is prudent to explore the more severe aspects of climate-related physical risks, which are expected to increase in the future, combined with risks that may materialise in transitioning to a lower carbon emitting economy, through a stress test of our largest banks”.

Nothing new under the sun  

The RBNZ has previously included climate-related scenarios in its stress tests. These have included drought, a series of severe storms, and flooding of residential properties. 

The ‘Too Little, Too Late’ scenario covers a 27 year period out to 2050, with most of the climate impacts occurring after 2030. 

It imagines a large number of countries rapidly increasing their carbon price after 2036 in an urgent effort to slow global warming. This could force a fast transition to lower carbon economies and create friction in labour markets, supply chains, and trade links. 

The late policy reaction means global temperatures could increase by 0.8° and reach 2° of warming by 2050. This could cause rising sea levels, lower productivity, drier summers and wetter winters, and less predictable, more extreme weather events. 

All this disruption causes economic growth to slow significantly in the 2030s as New Zealand and other global economies transition to lower-carbon emissions. 

Unemployment peaks at 7% and an extreme flooding event causes property prices to fall in some areas. Finally, an extreme drought leads to a credit ratings downgrade for banks.

There are some significant differences between this climate test and the traditional stress test. 

Notably, climate-related risks materialise over a long and uncertain time period. The modelling is also quite speculative, as this level of climate change is unprecedented. 

The RBNZ’s scenario suggests there would be little climate risk in the next seven years, with transition and physical risks only emerging in the early 2030s. 

The transition risk is highest through the latter half of the decade as even the slow-to-react countries push through last-minute transition policies. 

This risk is replaced with high physical risks between the 2040s and the 2050s as economies settle into a new normal, but extreme and unpredictable weather conditions persist. 

The economic fallout would be similar in magnitude to the Global Financial Crisis, but spread out over a much longer period of time.  

New Zealand’s climate outcomes will also depend on what happens globally and whether high carbon emitting countries manage to limit their emissions. 

Thinking short term

Michael Reddell, an independent economic commentator and former RBNZ advisor, said traditional stress tests were designed around an “out of the blue” shock. 

The most extreme financial system risks would only arise—in 20 years time—if banks were still lending as if severe adverse climate shocks had not become more probable. 

“It seems unlikely the Reserve Bank will be the only sort of entity to foresee risk,” he said. 

While many mortgages are written for 30-year terms, most are paid off sooner and inflation eats away at the value of a loan. This means the greatest risk for banks is concentrated in the first few years of a mortgage.  

“Bank balance sheets in 2043 will probably look quite different than they do now … If we are going to do climate stress events that actually matter, focus on events that might happen in the next year or two.”

A report by Deloitte said an increasing number of central banks had run climate scenario analyses or stress tests over the past four years. 

For example, the European Central Bank completed a climate stress test for 104 significant financial institutions last year. 

Sabine Mauderer, an executive board member of Germany’s central bank, discussed this test in a speech earlier this year. 

“Climate scenarios and climate stress tests are not perfect yet and the results they provide have to be taken with a grain of salt. Nonetheless, they are already viable instruments for shedding light on the exposure and resilience of banks to climate-related risks,” she said. 

It was a challenge for central banks to strike the right balance between short-term and long-term scenarios.

Standard stress tests usually look at time horizons of one to three years, while climate scenarios often look 10 to 30 years ahead. 

“These long time horizons carry the risk of climate scenarios underestimating the near-term impact of climate-related risk”. 

As central banks continue to work on climate scenarios, the analysis will become more usable and will “paint a clearer picture”.

A earlier version of this story incorrectly described the stress test as being a 23-year scenario. It has been corrected to 27 years.