Climate Risk and the ECB Stress Test

On July 8 of this year, the European Central Bank (ECB) released its first climate risk stress test. The report showed that banks within the euro zone have not incorporated sufficient climate risk into their internal models and frameworks for stress-testing.

This has worked to reaffirm the fact that banks will need to improve their climate risk strategies and make the environment a priority. Climate scientists around the world are warning that the time to change is essentially now or never if we are to prevent the worst outcome of the climate crisis. This has been made even more clear at a time where much of Europe is facing extreme heat and scarce amounts of rainfall.

In addition to changing weather patterns, Europe is also grappling with skyrocketing energy prices due to the ongoing conflict in Ukraine. Leaders are fearful their sanctions imposed on the Kremlin will cause Russia to stop supplying gas to the region. In fact, just this week, the European Commission implored countries to reduce their natural gas use by 15% until next spring. This will help prevent them from falling victim to Russia’s weaponisation of its fuel exports.

The ECB said that extreme weather (i.e., floods and droughts) matched with an unexpected hike in carbon prices would lead to a loss of at least €70 billion.

What did the test assess?

104 banks in total participated in this test. It provided vital information across three different categories: 1) climate stress-testing capability, 2) reliance on sectors with carbon emissions, and 3) how they performed under various scenarios over several planning horizons. It was found that an estimated 60% of banks were yet to have a framework for climate risk stress-testing. Additionally, the ECB reported that the majority of banks also do not include climate risk as a part of their credit risk models. When approving loans, only 20% of banks even consider the climate risk variable.

Ultimately what became evident is how banks still heavily rely on carbon-emitting sectors. In fact, they make almost two-thirds of their non-financial corporate customer income from industries whose greenhouse gas use is intensive.

The data that is available is meagre, and these kinds of reports understate climate-related risk because they can only reflect a portion of the actual danger. This is largely due to the fact that this particular report focused on market and credit risk and did not account for other indirect effects, like an economic downturn. Because of the current cost-of-living crisis, there is potential for an economic downturn, so it is pertinent this is taken into account.

However, the exercise is still an important part of making Europe’s financial system more climate minded. As they face increased pressure from environmental advocates and shareholders, banks must comply and develop more robust frameworks. This includes improving their governance structures, modelling techniques, and data availability.

Climate Risk

How are central banks responding?

According to Christine Lagarde, ECB president, the ECB is working towards steps to address climate change within their ‘monetary policy operations’. The ECB collects information that is both qualitative and quantitative. They say this will help them assess how prepared the sector is on climate risk. It will also allow them to determine the best practices for how to deal with this kind of risk.

Activist group Positive Money Europe is fighting to make finance more sustainable. They argue that banks will need to face reality very soon, as households within the euro zone will struggle to deal with more expensive fuel, higher living costs, increased mortgage payments due to rising interest rates, etc.

Among the first central banks to undertake climate stress tests were the Bank of France and the Bank of England (BOE). The BOE found that banks and insurers could expect larger capital requirements and up to a 15% loss of annual profit if they do not effectively prioritise and manage climate risk.

A separate review will be carried out by the ECB to assess progress towards incorporating climate risk into their business models. Banks are expected to meet targets by late 2024.

If you are looking to make your investments more sustainable, schedule a consultation with a Wealth Manager today. We are committed to working with you to make climate risk a crucial factor in your investment strategy.

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