Bridging the Last Mile: A Transmission Channel Framework for Derivatives Stress Testing Under Climate Scenarios

Climate risk is increasingly recognized as an important factor in financial modelling, with applications including stress testing where climate risk factors are used to influence market risk and credit risk. However, this “transmission channel” modelling faces several challenges, particularly in terms of data availability and the mismatch between the time horizons of climate risks and financial risks. Recent research, especially from central banks and regulatory bodies, is beginning to address these challenges. The International Swaps and Derivatives Association (ISDA) has developed methodologies to compute very short-term scenarios. In this paper, we illustrate how outputs from ISDA and other sources can be integrated for climate stress testing of key products listed on the Singapore Exchange (SGX). The main contribution of this study is the development of a structured “last-mile modelling” framework that combines country-level climate sensitivity scaling, stressed correlation inference modelling, and direct carbon cost transmission mechanisms to bridge macro-level climate scenarios with product-level financial risk. It provides a practical and extensible approach for climate stress testing across both listed and over the counter (OTC) markets.