The Macroprudential Challenge of Climate Change

This comprehensive joint report from the European Central Bank (ECB) and the European Systemic Risk Board (ESRB) examines how climate shocks can affect the European financial system, identifying transmission channels and amplifiers of climate risk. It finds that these risks can spread quickly, especially in the event of a disorderly transition to a low carbon economy, with consequent and serious impacts on companies, banks and financial stability.

Following a brief introduction, the report reviews data and measurement issues, outlining indicators of climate-related risks relevant to financial stability. It examines the climate-related exposures, vulnerabilities and potential contributions to systemic risk from a range of actors, including households, corporations and banks.

The study finds that pockets of vulnerabilities could be amplified by correlated shocks and overlapping portfolios. However, “a high degree of measurement uncertainty continues to hamper a fully accurate assessment of granular exposures to climate risks”, the authors say, especially at the regional and country level.

The assessment then turns to the forward-looking scenario analysis used in climate stress testing. The long-term horizons associated with these scenarios might underplay the potential for short-term and abrupt climate-related shocks, it warns, while model-derived estimates of climate impacts involve strong assumptions and proxies that add to uncertainty.

A high-level summary of methodological approaches for dynamic balance sheet modelling for the banking, insurance and asset management sectors is offered, along with estimations of the amplification risks from the interactions of these sectors.

The report also says that scenario analysis also suggests that climate risks might affect the financial system in a specific order. This would involve unforeseen climate shocks having an abrupt impact on market prices and portfolios, causing defaults and resulting losses for exposed banks.

The report then looks at policy considerations, reviewing existing evidence of the effectiveness of policy options and examining the interplay between a macroprudential approach to climate risks and other policies.

“As evidence accumulates on the systemic dimension of climate-related financial risk, so too does the case for a macroprudential response,” it says. “A broad collective policy response would forcefully address the unprecedented, path dependent and widespread impacts of climate change.”

The case for adapting existing policy instruments to address climate risks is also considered, focusing particularly on systemic risk buffers and concentration thresholds.

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