“Transition risk losses alone are unlikely to threaten EU financial stability”.
That was the headline used by the European Central Bank (ECB) and the European supervisory authorities to launch the results of their recent one-off climate scenario exercise modelled on the Fit-For-55 programme, which commits the EU to reducing net greenhouse gas emissions by 55% by 2030.
On closer examination, such a reassuring conclusion is far from warranted. Once again, central banks and regulators are guilty of fostering complacency about the scale of the financial risks posed by climate change over the remainder of the decade, let alone beyond.
Narrow scenario focus undermines risk assessment
The first problem with this exercise is that the ECB’s three scenarios are built on the assumption that the Fit for 55 package will be successfully implemented. The assumption of success is a dangerous way of planning, let alone stress testing.
While this narrow scope was mandated by the European Commission, it may be overlooked by many who will simply read the headlines as suggesting that the transition risks to delivering Fit for 55 are not threatening.
The first of the ECB’s two adverse scenarios is based on what they term as a “run on brown”, whereby investors shed assets of carbon-intensive firms as they suddenly downgrade their expectations. The resultant financial losses hamper the green transition, as carbon-intensive firms struggle to finance the greening of their activities.
It is commendable that the ECB has acknowledged the transition risks from a run on these assets and conducted a granular analysis of the first and second round losses across the EU financial sector.
However, the presumption behind this scenario is that markets are currently sceptical that Fit for 55 will succeed, which might justify carbon-intensive assets being shed were they to recognise that their scepticism is misplaced.
But since it is plausible to suggest that markets are indeed sceptical of the strategy’s chances of success, this surely ought to prompt policymakers to reflect as to why. Policymakers need to contemplate the possibility of failure, particularly those who are responsible for economic and financial stability.
Meanwhile, the macroeconomic shock in the second adverse scenario stems from an energy price jump, which seems inconsistent with the asset-shedding assumption that it shares with the first adverse scenario. Higher fossil fuel prices seemingly have no impact on carbon-intensive asset valuations, which is counterintuitive and potentially misleading.
Moreover, the second adverse scenario fails to consider how prolonged economic stagnation might undermine the political will necessary to deliver the scale of investment required by Fit for 55. Weak economic growth and investment losses of 20% or more could severely harm the ability and willingness of EU nations to invest on the scale needed to achieve the bloc’s net-zero targets. This oversight ignores the potential for a negative feedback loop whereby economic challenges hinder climate action, exacerbating both economic and climate risks.
Climate scenarios overlook global risks
The second major problem with the ECB’s analysis is that there are many other sources of transition risk even if Fit for 55 is implemented.
The most obvious and worrying aspect is the ECB’s failure to consider risks from outside the EU. The scenarios implicitly assume that the rest of the world will meet their transition goals alongside the EU. However, this assumption ignores the very real possibility of divergent speeds and directions in the global transition.
In particular, the actions of the US and China will have profound impacts on European financial stability. The potential for policy reversals in, and conflicts between, these countries, coupled with the US’s leading role in energy production and China’s dominance in key green technologies, is a huge potential source of risk.
In greening their activities, EU industries may encounter risks not just from going slower than others, but also from going faster.
Thus in the US, the new Trump administration is already signalling it will back track on previous climate commitments, stepping up oil and gas output in a way that could lead to huge price volatility.
By contrast, Chinese dominance in renewable energy equipment, electric vehicles and batteries may pose growing financial challenges to EU industry, which has been lagging behind.
Stranded assets and technology shocks underestimated
The ECB’s scenarios also don’t adequately address the critical issues of stranded assets and potential technology shocks. Stranded assets, particularly in the fossil fuel sector, could represent a bigger risk to financial stability than the exercise suggests.
As the world transitions to a low-carbon economy, many fossil fuel reserves may become “unburnable” without expensive carbon-capture technology, potentially leading to huge write-downs and losses for energy companies and their investors.
Moreover, the scenarios don’t explore the financial risks from disruptive technology pathways reflecting technical progress, policy shifts and trade frictions.
Investing in the wrong technologies could lead to significant losses. This could happen even in the green sector, triggering a “run on green”. For example, rapid advancements in certain renewable technologies could render earlier investments obsolete, creating a new category of stranded assets even within the green economy.
While the ECB’s scenarios focus primarily on transition risks, they appear to underestimate the potential impact of physical climate risks. As extreme weather events become more frequent and severe, their direct and indirect effects on the financial system could be substantial.
Moreover, the scenarios don’t seem to adequately account for the possibility of climate tipping points being anticipated or reached before the end of the decade, which could dramatically accelerate both physical and transition risks.
Model limitations and inconsistencies
The ECB’s exercise represents significant progress in acknowledging and addressing the fact that financial markets and the economy could be causes rather than just casualties of transition risk. But on top of conceding that “not all scenarios, nor all severities, are considered – meaning that more severe scenarios could emerge, potentially leading to more severe impacts”, it notes other key limitations.
One important limitation is the assumption of static balance sheets, albeit partially relaxed for banks, which may not accurately reflect real-world dynamics and adaptations in the financial sector. Financial institutions are likely to adjust their portfolios and strategies in response to evolving climate risks, and failing to account for this dynamic behaviour could lead to inaccurate risk assessments.
In addition, the analysis focuses only on assets and, in the case of banks, it covers less than half of total assets.
It excludes liabilities and income effects which might mitigate losses, especially in the adverse scenario. This narrow focus on assets provides an incomplete picture of financial institutions’ overall risk exposure and resilience.
The way forward for ECB climate scenarios
The limitations of the Fit for 55 climate scenarios mean that headlines suggesting that transition risks are unlikely to threaten the delivery of the EU’s emissions reduction strategy are worryingly misleading.
To address the flaws in its thinking, the ECB needs to consider a range of improvements in future climate scenario work.
- Develop a wider range of scenarios, including those that consider policy failures, varying global transition speeds, and different pathways for geopolitics and financial markets.
- Incorporate global factors and risks triggered outside the EU, recognising the interconnected nature of the global economy and financial systems.
- Explicitly model the impact of stranded assets, both within and outside the EU, to better understand the potential financial implications of the low-carbon transition.
- Include scenarios that explore the financial risks surrounding different technology pathways and potential disruptions.
- Enhance model sophistication to better capture the complexities of climate-related risks, including non-linear effects and feedback loops.
- Improve the treatment of physical risks, including the potential for non-linear increases in extreme weather events and reaching climate tipping points.
- Conduct reverse stress tests to determine what scale of loss would jeopardise financial stability, providing insights into the system’s vulnerabilities.
Such improvements will clearly take time to implement. But in the meantime, the ECB can at least change its narratives to help guide financial institutions and policymakers through the inevitable global uncertainties that we face.
Scenarios need to be fit for purpose, not just Fit for 55.
This page was last updated January 31, 2025
Written by
Mark Cliffe an economic consultant specialising in sustainability. He is also currently a visiting professor at the London Institute of Banking & Finance, a visiting fellow at the Global Systems Institute at the University of Exeter, and associate business fellow at the UK Centre for Greening Finance and Investment. Previously, he was chief economist at ING Group.
