Stress Testing Climate Scenarios: Integrating Environmental Risks into Financial Models

Abstract

This study examines the growing integration of environmental risks into financial stress testing frameworks in response to the escalating impacts of climate change on global economic stability. Using a Systematic Literature Review, the research synthesizes evidence on how physical and transition risks reshape credit, market, and liquidity conditions, challenging the adequacy of traditional linear financial models. The findings reveal strong regulatory momentum, led by institutions such as the Network for Greening the Financial System and the Financial Stability Board, which increasingly promote forward-looking climate scenario analysis. Empirical applications, including the European Central Bank’s climate stress test, demonstrate methodological advancements but also expose substantial limitations in climate data, scenario design, and the modeling of non-linear climate dynamics. The review highlights persistent gaps in capturing the interaction between physical and transition risks, as well as the underestimation of tail events in existing models. Overall, the study underscores the need for greater methodological innovation, enhanced data availability, and interdisciplinary collaboration to improve the accuracy and decision usefulness of climate stress tests. Strengthening these elements is essential for developing more resilient financial systems capable of navigating the accelerating risks associated with climate change.