Macroprudential tools could limit spread of climate shocks, says ECB

Climate risk shocks could rapidly spread throughout the eurozone financial system, with linkages between institutions amplifying potential losses, according to a paper published this week by the European Central Bank (ECB) and European Systemic Risk Board.

The authors say the report further illustrates the systemic nature of climate risks and shows the need for a macroprudential policy response.

The ECB is already pushing banks to bolster their management of climate risk via a suite of microprudential measures, such as its ongoing thematic review of climate risks and the 2022 climate risk stress test. It has expressed frustration with institutions’ slow progress to date, and the latest report finds euro area banks achieved no meaningful reduction in the emission intensity of their loan portfolios in recent years.

The paper examines how the effects of shocks from the green transition – such as a surge in carbon prices – could reverberate beyond high-carbon companies and banks. It suggests climate shocks will have an abrupt impact on market prices, initially hitting the portfolios of investment funds, pension funds and insurance companies. This sudden repricing will then lead to defaults and losses for lenders.

The report considers how macroprudential tools could be adapted to complement the steps the ECB is already taking at the microprudential level. In particular it presents the case for adapting systemic risk buffers and concentration thresholds, concluding that such instruments could be applied to tackle climate risk with limited adjustments.

The ECB has previously acknowledged that its current capital regime does not capture climate-related financial risks, owing to the fact that the underlying risk weights do not yet reflect the full extent of the climate-related risks banks face.

Members of the ECB’s supervisory board have been reported as saying they would begin work on climate-adjusted capital rules following the publication of the climate stress test this summer. The governor of the Banque de France, François Villeroy de Galhau, said in March that capital rules could be linked with banks’ climate transition plans, with capital add-ons applied to banks that are misaligned with the goals they have set out.

The proposals offered by Villeroy and others would involve calibrating capital requirements based on an assessment of the climate risk of individual institutions, whereas this week’s report considers how systemic risk buffers might be used as a general tool, and applied across asset classes or sectors.

“The sectoral use of the systemic risk buffer may be an adequate tool to discourage concentrated exposures, as concentrations may occur in terms of both banks exposed to, and sectors most vulnerable to, climate risks and may also incentivise banks to adapt their balance sheets,” say the authors.

The study will cause further concern about the particular vulnerability of some eurozone households to climate risks, as it reveals that almost half of outstanding mortgages are to borrowers with stretched energy cost-to-income levels.

Civil society groups have warned about the “triple whammy” faced by mortgage holders as they grapple with rising living costs, soaring energy bills and higher mortgage repayments. Under the banner of the Unlock campaign, NGOs and several members of the European Parliament are calling on the ECB to support EU green home renovation initiatives.