This paper proposes a comprehensive climate stress testing approach to measure the impact of transition risk on investment portfolios. Unlike most climate stress testing models, which are designed for the banking industry and follow a top-down approach, our framework considers a bottom-up approach and is mainly relevant for the asset management industry. In this paper, we model the distribution function of the carbon tax, provide an explicit specification of indirect carbon emissions in the supply chain, introduce pass-through mechanisms of carbon prices, and compute the probability distribution of potential (economic and financial) impacts in a Monte Carlo setting. Rather than using a single or limited set of scenarios, we use a probabilistic approach to generate thousands of simulated pathways. We can then examine the impact of transition risk at the economic level and analyze inflation, growth and earnings risks at the sector and country level. We also propose a framework for modeling earnings-atrisk and asset-return shocks at the issuer level. Finally, by combining value-at-risk and stress testing approaches, we define appropriate risk measures for managing climate risk in investment portfolios and asset allocation.
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