The Double Materiality of Climate Physical and Transition Risks in the Euro Area

A major barrier to assessing the double materiality of climate-related financial risks is a lack of knowledge about how bank climate risk assessments and the carbon pricing expectations of companies affect investment decisions and thus climate mitigation trajectories. To fill this gap, this working paper from the European Central Bank uses Network for Greening the Financial System (NGFS) climate scenarios to offer a dynamic assessment of how climate physical and transition risks affects euro area balance sheets.

The study uses a modified Eirin macroeconomic model to run a dynamic assessment of physical and transition risk scenarios in the euro area economy and banking sector. Climate-related risks affect the profitability and investment decisions of firms, which in turn affect banks and other financial actors holding loans and securities. The climate risk assessments of these financial institutions influences the cost of capital and access to credit for firms. The resulting adjustment in the structure of the economy, in turn, affects the realisation of climate transition and physical risk scenarios.

Agents in the model are represented as a network of interconnected balance sheets and calibrated on real data, making it possible to trace a direct correspondence between stocks and flows.

The analysis also examined the impact of firms’ expectations about the impact of carbon pricing on their business under the NGFS scenarios. The role of finance and of the uncertainty associated with investors’ expectations is important to avoid underestimating the cost of inaction and eventually the impact on GDP, the authors say, but these are currently missing from NGFS scenarios.

The study finds a significant difference between an orderly transition – with mid-term benefits for emissions abatement, financial stability – and economic output, and a disorderly transition that would threaten financial stability and reduce firms’ capacity to invest in low-carbon activities. It also shows an important role for carbon pricing expectations across the NGFS scenarios, especially in smoothing the transition in the economy and financial system.

The analysis also found that the impact on GDP of orderly and disorderly transitions are highly influenced by the magnitude of shocks in NGFS scenarios, while warning that these scenarios do not include acute physical risks or their potential compounding. There is an “urgent need” to strengthen climate physical risk scenarios in order to avoid underestimating risks, the authors say.

“Our results highlight the importance of considering the interplay between the economy and the financial sector in the assessment of climate transition and physical risks,” the study concludes. “In this regard, macro-prudential policies could be considered in order to mitigate climate-related financial risks for banks.”