Scenario Analysis and Stress Testing for the GARP SCR Exam
- Kateryna Myrko
- Aug 10
- 4 min read
Scenario analysis and stress testing are essential components of the GARP Sustainability and Climate Risk (SCR) curriculum, equipping risk professionals to quantify, manage, and communicate climate-related financial risks effectively. In a world increasingly shaped by climate policy shifts and physical climate impacts, mastering these tools is crucial for passing the GARP SCR exam and applying insights to real-world portfolio and institutional risk management. GARP SCR Exam , Scenario Analysis and Stress Testing
What is Scenario Analysis? GARP SCR Exam , Scenario Analysis and Stress Testing
Scenario analysis involves developing plausible, coherent climate futures and assessing their impact on an institution's financial and operational profile. It is not a prediction exercise; instead, it helps gauge how portfolios may respond under different pathways, such as a rapid transition to net-zero emissions or delayed policy actions leading to physical climate escalation.
Examples of scenarios include:
IPCC RCP 2.6: Paris-aligned scenario with strong emissions reduction.
RCP 8.5: Business-as-usual, high-emission scenario with severe warming.
NGFS Scenarios: Central bank-focused frameworks integrating transition and physical risk pathways.
Using these frameworks, risk managers evaluate factors such as temperature rise, carbon pricing, and policy interventions and translate them into portfolio-level impacts.
What is Stress Testing?
Stress testing simulates severe yet plausible adverse conditions, including sudden policy shifts or extreme weather events, to evaluate an institution's resilience. Unlike scenario analysis, which often focuses on gradual changes across multiple pathways, stress testing is event-focused, assessing short-term impacts under extreme conditions.
Examples:
A sudden carbon tax increase that materially impacts energy-intensive sectors.
Severe flooding or wildfire events disrupting physical assets and supply chains.
Stress testing complements scenario analysis by testing tail risks and the adequacy of capital buffers under climate shocks.
Why They Matter for GARP SCR and Institutions
Regulatory Expectations: Frameworks such as TCFD, NGFS, and local regulators require climate scenario and stress testing integration into risk management.
Enhanced Risk Management: Identifies hidden vulnerabilities within portfolios, supporting proactive reallocation and hedging strategies.
Strategic Planning: Provides insights for board-level discussions, influencing capital planning, underwriting standards, and long-term sustainability objectives.
Stakeholder Communication: Supports transparent reporting to investors and regulators, demonstrating climate risk preparedness.
Framework for Scenario Analysis and Stress Testing
1. Scenario Design
Use reference scenarios (IPCC, NGFS) while tailoring parameters to institutional portfolios.
Include variables such as temperature trajectories, carbon prices, and policy assumptions.
2. Data and Risk Drivers
Gather climate data aligned with selected scenarios.
Map exposures to transition risks (e.g., carbon-intensive sectors) and physical risks (e.g., flood-prone properties).
3. Modeling Approach
Top-down: Aggregate scenario impacts at the macro-portfolio level.
Bottom-up: Assess exposures and sensitivities at the individual asset or counterparty level.
Hybrid approaches are often used to capture portfolio-level impacts while maintaining asset-level insights.
4. Analysis and Aggregation
Calculate impacts on credit, market, operational, and liquidity risks.
Aggregate impacts across business units to understand systemic vulnerabilities.
5. Governance and Escalation
Define thresholds that trigger management action.
Integrate findings into the institution’s risk appetite and capital planning.
Types of Analysis to Master for the Exam
Historical Scenario Analysis: Uses past climate events as a baseline for impact assessment.
Hypothetical Scenarios: Projects climate pathways under different assumptions.
Reverse Stress Testing: Identifies scenarios that could lead to severe losses, working backward to define conditions.
Sensitivity Analysis: Examines impacts of varying key climate parameters within a scenario.
Practical Example
A bank assesses its mortgage portfolio against a scenario of rapid carbon taxation leading to increased energy costs:
Identifies geographic areas where housing affordability would decline.
Quantifies increased default probabilities.
Measures impact on capital requirements.
Develops contingency plans such as modifying underwriting criteria and geographic exposure limits.
Challenges and Mitigations
Challenge | Mitigation |
Scenario bias | Use multiple scenarios and reference frameworks to reduce subjective assumptions. |
Data limitations | Use proxies and collaborate with vendors for consistent climate data. |
Shifting correlations | Update models regularly to reflect evolving climate-financial linkages. |
Model risk | Validate models with back-testing and expert input. |
Exam-Focused Tips
Understand Definitions: Be clear on the distinctions between scenario analysis, stress testing, reverse stress testing, and sensitivity analysis.
Know Frameworks: Familiarize yourself with NGFS and IPCC scenarios and their parameters.
Link to Risk Types: Explain how scenarios translate into credit, market, operational, and liquidity risk impacts.
Apply Examples: Use practical examples in your answers to illustrate application and value.
Discuss Limitations: Acknowledge the challenges in scenario analysis and stress testing and propose realistic mitigations.
Connect to Governance: Emphasize how scenario results feed into board discussions and capital planning.
Scenario analysis and stress testing are not only exam requirements for GARP SCR candidates but critical tools for integrating climate risk into institutional risk management. They allow firms to understand vulnerabilities, prepare effective mitigation strategies, and align with evolving regulatory expectations.
By mastering these techniques, you will strengthen your capability to quantify and manage climate-related risks systematically while advancing your professional expertise in climate risk and sustainability.
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