6.1. Stress tests

Institutions should incorporate environmental factors into their stress testing framework, elaborated in accordance with the EBA Guidelines on institution’s stress testing.

In accordance with Article 177(2) and (2a) of Regulation (EU) No 575/2013, institutions using the IRB Approach are required to regularly perform credit risk stress tests which shall consider the effects of severe, but plausible, recession scenarios’ and which shall include ‘ESG risk drivers, in particular physical risk and transition risk drivers stemming from climate change’ . The methodology for performing stress tests in accordance with this Article should be consistent, to the extent appropriate, with the methods set out in Section 4.7.1 of the EBA Guidelines on institutions’ stress testing, and in this section.

For the purposes of their stress testing exercise, institutions should use a baseline scenario, as well as a set of adverse scenarios which are defined as severe (i.e. tail risk) but plausible (i.e. reasonably probable) scenarios.

When defining their baseline scenario, institutions should assume a continuation of current conditions and trends, including expected trends in environmental risks, without assuming extreme shocks or policy shifts. The baseline scenario should take into account, where likely to have material impacts, the policies adopted or about to be adopted over the period under consideration.

For the set of adverse scenarios, institutions should consider environmental shocks as shocks among others. When shocks of different origins combine, institutions should examine in greater depth the consequences of these compound risks that could amplify the impacts beyond a simple aggregation of the impacts of the climate, environmental and macroeconomic scenarios analysed separately.

When incorporating environmental variables into their existing stress testing framework, institutions should conduct a thorough gap analysis of their stress testing models to identify areas where current modelling capabilities need to be improved to adequately account for environmental risks. Given that environmental risks are not primarily captured by economic variables, institutions should consider an in-depth overhaul of their approaches, rather than multiple ad-hoc adjustments.

To facilitate a smooth integration of the environmental variables, institutions may need to test the new approaches or environmental risk modules separately before their full integration. In the testing phase, institutions should apply caution when using the results of stress tests for decision making. FINAL REPORT ON GUIDELINES ON ENVIRONMENTAL SCENARIO ANALYSIS

Institutions should ensure that industry sector and country or geographical location dimensions are properly taken into account in their stress test models. While developing new models or extending the granularity of existing models, institutions should introduce variables sensitive to environmental risks in connection with the identification of transmission channels provided for in Section 5.1.

Where possible and taking into account their materiality assessment, institutions should apply environmental shocks related to adverse scenarios directly at the exposure level. For risks whose materiality is primarily the result of a concentration effect, institutions should apply the shocks to groups of counterparties with a similar profile of exposure to environmental risks.

Institutions may use a constant balance sheet assumption, but are encouraged to incorporate, as far as possible, significant changes in the composition of their portfolios resulting from the institution’s approved strategy, where these are due to occur during the stress test period. As a complement, institutions may use a full dynamic balance sheet approach according to their practices and needs.

Institutions should progressively incorporate environmental factors into their stress testing models, starting with credit risk models, and aiming at capturing gradually the impacts of environmental changes on other traditional risk categories, including market, operational, and liquidity risk across all relevant portfolios, sectors, and geographies.

By way of derogation from paragraph 15 of the EBA Guidelines on institutions’ stress testing, institutions are not required to incorporate environmental risks into their reverse stress testing. They may do so on a voluntary basis if they deem it useful.