Euro Area Banks’ Sensitivity to Changes in Carbon Price

A delayed and abrupt increase in carbon prices during a disorderly transition would be a serious risk to financial stability, finds this working paper from the European Central Bank. It warns that a sudden rise in carbon prices to over €150 per tonne could cause a major financial shock, calling on policy-makers to raise carbon prices early and gradually.

The study combined a unique granular dataset with a banking sector contagion model in which firms are negatively impacted by an increase in carbon prices. It found that early policy action, a gradual rise in carbon prices and effective emissions reduction by companies would lead to minimal impacts on the banking system. However, if no action is taken then abrupt and large increases in carbon prices may lead to severe banking system losses.

In order to hedge themselves from these climate-related transition risks, the authors suggest that banks should restrict their lending to less polluting firms, lend to firms with ambitious emissions reduction targets, and help their clients to transition to low carbon business models. It also finds that regulators may need to implement further prudential measures to prevent the build-up of banking system losses.

The analysis also finds that big increases in carbon prices might still entail tail risks for the banking system if firms reduce emissions only lightly. However, when combined with ambitious and Paris-aligned emission reductions at firm level, large increases are not likely to put systemic stress on the banking syste

“Overall, results presented here suggest that in order to shield themselves from losses, banks should assess lending to firms that are not following ambitious emission reduction strategies,” the paper concludes, calling for policy measures to encourage banks and firms to report emissions disclosures and verifiable reduction strategies.

The paper ends by contrasting the relatively limited financial losses associated with carbon pricing to the vast physical consequences of climate change.

“Banking system losses… seem to be limited compared to the physical consequences of climate change documented in the literature,” it says. “Global consequences of unmitigated climate change may trigger currently unforeseen consequences, ranging from climate system changes by crossing climate tipping points, to strongly decreasing the area of habitable places on Earth, threatening lives and the economic and political stability of societies.”