Green award: Reserve Bank of New Zealand

The Reserve Bank of New Zealand has long been a pioneer, most notably as the first central bank to set rates independently in pursuit of an inflation target. Its latest innovation – embedding climate risks into its bank stress-testing programme – could prove to have an even greater impact.

Stefan Gray, the RBNZ’s manager for strategic climate initiatives, says the work not only helped the central bank to fulfil its core mandate; it also provided an opportunity to support lenders engaging in their first year of New Zealand’s mandatory climate-related disclosure regime.

“We incorporated things we thought were appropriate from a financial stability lens,” he says. “We see climate change as posing financial stability risks that need to be monitored for our core objectives to be met. But we also understand that the wider financial system requires a capability ‘lift’ to be able to manage climate-related risks. The uncertainties are novel, the data is typically new, and there are new skills and systems that need to be built. There’s a need for collaboration to help both sides of the equation – companies and regulators – make progress.”

As its starting point, the RBNZ refined the scenarios outlined by the Network for Greening the Financial System to account for the specific risks New Zealand was facing. “We’ve got a large agricultural sector that could be prone to drought, so we added a physical event to reflect that,” says Ken Nicholls, the bank’s stress-testing team leader. “The flooding risk for mortgages was something we also wanted to test.”

The central bank also added events that would not normally crop up in regulatory climate stress tests, such as a ratings downgrade that would increase the cost for banks of securing funding.

“We tried to factor in the worst of both worlds,” says Nicholls. “We followed a delayed transition scenario – we still had the global average temperature rising by two degrees by 2050, but we assumed there would be two cohorts of countries: some lower-emitting countries that transitioned first, like New Zealand, and the larger-emitting ones that transitioned later but had to do it quickly. So, we had the NGFS’s current policy scenario for the climate and physical risk, which relates mainly to productivity. And then we had the impact of the delayed transition coming through as well. On top of that, we added all those extra components for New Zealand – the ratings downgrade, flood events and drought – and we did quite a lot of modelling of the impact on GDP.”

Jonathon Adams-Kane, the RBNZ’s adviser for stress-testing, says its scenario ended up being more severe than the NGFS’s because it factored in New Zealand-specific risks. “We had significant emissions pricing on agriculture in addition to droughts, and emissions pricing specifically for agriculture doesn’t feature in the NGFS scenarios,” he says. “But that’s quite important for us, even if it’s not for many large, advanced countries.”

When it came to fleshing out the specific financial impacts on firms, the RBNZ left it to the banks to develop their own credit risk modelling. It wanted to assess climate-related risks for New Zealand’s five largest banks, which amount to around 90% of exposures in the country’s lending market. These lenders also had to come up with climate-related operational risk events – such as physical damage to property and legal action from selling mortgages in flood-affected areas – and incorporate them into the stress test.

“We’d already asked the banks to build up their data collection on climate-related risks, and this enabled us to put together a full climate stress test over a 28-year period out to 2050,” says Nicholls.

This is a much longer timeframe than the banks had been used to. Nicholls says it involved moving away from stress-testing capital ratios and focusing more on dividends and profitability over a longer period.

“We found the dividends would fall by about 40% over the 28-year period, and that would reduce the banks’ resilience to other shocks,” he says. “That prompted a discussion involving the banks’ risk management people and the CFOs about how these things could play out. They said that having numbers around it, rather than just talking qualitatively all the time about climate-related risks, really informed that conversation.”

Adams-Kane says that when it came to agriculture and home loans, the RBNZ pushed banks to do credit risk modelling at a micro level by looking at individual customers, properties or loan levels.

“Modelling of non-agri business borrowers generally isn’t at that stage yet, but several banks are developing their databases so they’ll be able to introduce that kind of granular level modelling,” he says. “Even for mortgages, banks are still missing some important variables – they typically don’t have floor height for properties, for example, and they have to make assumptions when that’s important for flood risk. A difference of even half-a-metre of floor height can have a significant impact on the flood risk for a property.”

The RBNZ asked the banks to come up with mitigation measures they could put in place, such as repricing loans to account for climate-related risk. “If a property was in a flood plain area, that would potentially lead to higher pricing,” Nicholls says. “The banks did talk about getting loan managers to take account of these risks in the scenario. There were also discussions about supporting their agri customers on plans to reduce emissions. So, there are specific actions that banks are going to take as a result of the stress test.”

Devising the stress test also meant factoring in the economic realities of New Zealand’s status as a smaller nation.

“If a very large country moves more decisively on emissions pricing, it’ll end up with somewhat lower physical risks, because its policies are mitigating actual climate change,” says Adams-Kane. “A small country like New Zealand can go quite hard on policy, but if many larger countries aren’t doing that, the physical outcomes could be just as bad as they would have been if you weren’t going hard.”

“We’d also be at a bit of a trade disadvantage because we’d already put up emissions pricing but other countries hadn’t, which we factored into our projections for GDP,” says Nicholls.

Insurance retreat was another factor the stress test took into consideration. Climate change is likely to make insurers increasingly reluctant to cover properties in areas at risk of sea level rise or fluvial flooding, which will have a detrimental effect on property values.

“Whether at-risk properties will maintain accessible and affordable insurance, and whether people will be able to get mortgages for them, is understandably a significant focus here – as it is in many other jurisdictions,” says Gray.

Moreover, lenders are not always aware of whether a property is insured.

“Banks typically have a requirement in their mortgage contracts that a property is insured, but they often only check that when the policy is originated,” says Adams-Kane. “After 12 months, when the policy must be renewed, they no longer know if a property is insured.

“The conversations we’ve had with banks about insurance retreat have elevated it as an issue. The banks are now looking more actively at it, and the insurance industry is also more aware of the banks’ need to find a way to monitor the insurance status of properties.”

Gray says that, because of the climate stress test, banks and insurers are working with their clients to find ways of reducing their exposure to transition and physical risks. “They don’t want to be losing their social licence to operate, or their market share,” he says. “They’re doing what they can to stay with their current client base and counterparties by sourcing better information that will help their clients and then working with their clients on the potential options to reduce the risk exposure in their portfolios.”

Other countries are already showing an interest in New Zealand’s approach. “The NGFS was impressed that our test was customised and that frictions were added to make it appropriate in a jurisdictional context,” says Gray. “We’ve had follow-ups from the Philippines and Namibia – small, exposed economies that see the value of this type of approach, and particularly in bringing physical and transition risk together in the way that we have.”

The Central Banking Awards 2025 were written by Christopher Jeffery, Daniel Hinge, Daniel Blackburn, Joasia Popowicz, Riley Steward, Jimmy Choi, Levente Koroes, Thomas Chow and Blake Evans-Pritchard.