Report: European financial stability at risk from climate shocks

A new joint report from the European Central Bank (ECB) and the European Systemic Risk Board (ESRB) has found that climate-related shocks could spread quickly through the European financial system, affecting households, companies and banks.

The comprehensive study outlines ways in which both physical and transitional climate impacts can be transmitted and amplified through the economy, resulting in a threat to financial stability.

The analysis shows that interdependent physical effects of global heating can amplify physical climate risk by clustering together and exacerbating each other, using the example of drought conditions heightening heat stress,leading to larger and more frequent wildfires. Market dynamics can then magnify the financial impact of these events through the sudden reassessment of climate risk pricing, for example causing fire sales of exposed assets at distressed prices.

Financial market losses from this “hot potato” effect could in turn affect investment funds and insurers, as well as triggering corporate defaults and corresponding credit losses for banks.

Transition risks are also a potential source of climate-related shocks to the economy and financial system, the report says, and can also be magnified because of economic and financial linkages between and across banks and companies. One example would be a surge in carbon prices leading to a cascade of defaults. While this is a particular vulnerability of high-carbon companies, less carbon-intensive counterparties can also be affected as the default of one company leads to the default of another, with knock-on effects for exposed banks.

The scenario analysis used in the study also suggests that the materialisation of climate risks would affect the financial system in a specific order. Unforeseen climate shocks could occur first and have a sudden impact on market prices and portfolios, which then cause defaults, resulting losses for banks and consequent threats to financial stability. Risk propagation within the financial system appears to be most relevant for banks, the study suggests.

Overall, the analysis shows how climate risk shocks could spread throughout the financial system, particularly in the event of a disorderly green transition.

“A growing body of empirical evidence on climate-related risks to financial stability has now provided a robust analytical foundation for macroprudential policy considerations, spanning both the cross-sectional and time series dimensions of systemic risk,” the report says, adding that its findings “provide a foundation for a macroprudential policy response”. It presents the case for adapting existing instruments as part of this response, focusing on systemic risk buffers or concentration thresholds.

“The report adds further evidence on the systemic nature of climate risks and provides a foundation for a macroprudential policy response,” the ECB said in a statement announcing the report.

This is the third joint ECB/ESRB publication on climate risks to European financial stability, following an initial overview report and a second report covering climate-related indicators and measurement issues. The joint ECB/ESRB climate risk project team that produced the report will now focus on developing a permanent financial stability surveillance framework for climate-related risk.