Last Friday, the European Central Bank (ECB) published the results of its bottom-up 2022 climate risk stress test. The results are one of the significant deliveries under the ECB Banking Supervision’s strategic priorities for 2022-24 and follow the ECB economy-wide top-down climate stress test released in September 2021.
The results draw major attention from policymakers, as the EU´s banking prudential regulation is currently undergoing a review.
What is the ECB climate stress test?
Contrary to the Basel Committee’s definition of a stress test, which should evaluate banks’ financial position under severe but plausible scenarios, the ECB climate stress test was, as stated in the report, a learning exercise to enhance “both banks’ and supervisors’ capacity to assess climate risk”.
Due to data and methodological challenges, the ECB is not yet in the position to conclude whether banks will be able to withstand financial losses resulting from extreme climate-related events and transition to a carbon-free economy.
The ECB clarified that the climate stress test would have “no direct capital implications” in contrast to its “traditional” financial stress tests. Therefore, per the Basel Committee definition, the exercise represents just an exploratory scenario analysis – a fundamentally different tool from a true stress test.
This significant nuance often gets lost when the stress test results are made public, given the enormous signalling power of ECB actions and the traction that stress tests gained in supervisory communication.
How should the results be interpreted?
The ECB estimates that 41 of the largest EU banks could potentially lose €70bn over the next three years due to climate-related risks – a figure dwarfed by over €1.6tn of capital and over €25tn of assets of the ECB-supervised banks. This result suggested many “all-clear“ reactions playing into the hands of those who oppose decisive action to address climate risks.
However, the long list of limitations of the stress test exercise calls into question the usefulness of the loss estimate. The fact that banks cannot accurately account for climate risk using their existing credit risk models suggests the infancy of the effort.
The ECB report does not allow for much digging into detail, as €70bn is the only loss number included. It covers only 41 out of 104 significant banks and accounts for only one-third of their total exposures. Comparison to the capital position and total assets of the banks analysed is not provided in the report to put the result into perspective.
The €70bn loss figure only covers the losses from the three-year transition risk and one-year physical risk scenarios. These time horizons are at odds with that of climate change. The ECB remained silent on the potential losses to the banks in its 30-year scenario.
Thus, the result is of limited use in weighing the potential financial cost of climate change.
The most severe climate stress test scenario in the report does not include any economic downturn accompanying the negative climate effects. World GDP is projected to grow by 57% in 2050 compared to 2021. Even in the “hothouse world” scenario – the scenario in which no new climate policies are implemented – global emissions grow until 2080, leading to about 3°C of warming.
This compares strikingly to the projections of -18% global GDP impact in the analyses done by Swiss Re. Importantly, physical risk scenarios do not capture major climate-related disruptive events that we are likely to see once tipping points beyond a 2ºC temperature rise are reached.
What do the results mean for the EU climate risk agenda?
Policymakers increasingly look for climate stress test results to drive policy implications. The timing of the stress test results is more important than ever when the EU banking prudential rules are under review and members of the European Parliament are working on the amendments to the capital requirements regulation and directive.
If anything, the ECB report shows that there are many known unknowns, but there are even more unknown unknowns regarding climate risk. The nascency of the climate risk measurement capabilities is alarming given the period we have to prevent further irreversible changes to the climate.
Regulators should pay attention to the worrying insights in the ECB report, such as the fact that global systemically important banks hold the largest share of exposures to the most carbon-intensive industries. Risk concentration in the largest systemically essential banks means we could end up back at the too-big-to-fail scenario once climate risks start materialising.
And while the work on climate-related risk data and methodologies continues, the only conclusion remains unchanged: the clear, undeniable benefit of acting early.
This article was first published by Euractiv.
This page was last updated July 12, 2022
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