© Michael Marais
European regulators have unveiled the results of their first financial-sector-wide climate stress test. While they concluded that risks from the green transition alone are “unlikely to threaten financial stability”, they identified potential for more significant losses when risks intersect with broader macroeconomic shocks.
The European Central Bank (ECB), in collaboration with the EU’s supervisory bodies, conducted the exercise to gauge the impact of the EU’s decarbonisation plan on banks, investment funds, and the pension and insurance sectors. Specifically, they investigated how these sectors would respond to the full implementation of the EU’s green energy reform package, known as Fit for 55.
The results showed that in the most severe macroeconomic scenario losses of over €630bn are possible for the banking sector, nearly 90% higher than under baseline macroeconomic conditions.
The test modelled three scenarios over an eight-year horizon, including a baseline and two adverse scenarios. The most severe scenario combined investor abandonment of carbon-intensive assets, leaving those firms without finance to transition their operations, with macro-financial stressors.
The results revealed that carbon-intensive sectors, particularly mining and transportation, faced substantial increases in default probabilities under these conditions, with rises of 5.4 and 3.6 percentage points respectively.
Investment funds emerged as particularly vulnerable to these impacts due to their exposure to high-carbon assets. Once second-round losses are considered, investment funds face potential losses of up to 25% of asset values in the most adverse scenario.
ECB acknowledges stress test limitations
Reflecting on the outcomes of the exercise in a blog on the ECB website, Luis de Guindos, ECB vice-president said: “The good news is that … the overall stability of the financial system is not at risk under these specific adverse scenarios. However, the substantial losses under the second adverse scenario highlight the need for financial institutions to properly manage climate-related risks. Moreover, a coordinated policy approach to financing the green transition is essential.”
The ECB acknowledged several limitations of the exercise, including its static balance sheet assumption which overlooks how financial institutions may act to mitigate losses.
Given the novelty of the methodological approaches, which included cross-sectoral assessments as well as data-related challenges, the ECB also cautioned that the results are subject to a large margin of uncertainty.
Another significant limitation of the exercise is that it does not include physical risks in its scenarios or explore the costs of delayed or disorderly transition scenarios as counterfactuals.
Fundi Tshazibana, vice-chair of the Network for Greening the Financial System, emphasised the need for more sophisticated modelling of transition risks at this year’s Green Swan conference. By incorporating the physical impacts of climate events, central banks can produce more “dynamic reflections”, she said.
This page was last updated December 9, 2024
Written by
Ike Walker, a Green Central Banking contributor since 2023, has a decade's experience in research writing. An Utrecht-based scholar, Ingrid specialises in transformative justice, green finance, law and systems change. They are an Utrecht University's Bright Minds scholar and previously worked for Cambridge University and various justice-based NGOs.
