ECB stress test reveals potential climate peril for European banks

A climate stress test by the European Central Bank (ECB) has found firms based in areas most open to physical risk could see their creditworthiness impacted by climate change.

The test scrutinised the impact of climate change on over four million companies globally and 1,600 Euro area banks under three differing climate policy scenarios.

According to the ECB, the results from the test show that businesses and banks clearly benefit from adopting green policies early on in order to foster the transition to a zero-carbon economy.

However, the exercise discovered that the impact of climate risk is concentrated in specific regions and sectors of the euro area – with those regions that are most exposed to physical risk at risk from frequent natural disasters, which could subsequently affect their creditworthiness.

The ECB underlined that climate risk includes both physical and transition risk, with the former being the economic impact of an expected increase in the frequency and magnitude of natural disasters. Meanwhile, transition risk is the cost of introducing policies to reduce carbon emissions, specifically for certain high-emitting industries.

The stress-test identified that Euro area banks could be ‘severely affected’ under a scenario where climate change is not dealt with, with losses on corporate loan portfolios anticipated to rise substantially over time, driven by ever-growing physical risk, with the possibility of the risk becoming critical over the next 30 years.

Furthermore, the ECB detailed that the average corporate loan portfolio of a Euro area bank is 8% more likely to default under the hot house world scenario than under an orderly transition in 2050. Portfolios most vulnerable to climate risk are also 30% more likely to default in 2050 compared with 2020 under the hot house global scenario – an increase that it five times larger than the average increase under the same scenario.

The ECB mentioned that the final climate stress test results are in line with the preliminary results publishing in March this year and complement these findings by including assessments of banks’ resilience to climate risk through loans, equity holdings and security.

The bank noted that the test ‘marks the first step in the ECB’s climate roadmap’ and the results and methodology will inform the 2022 supervisory climate stress test for the banks that the ECB directly supervises, as well as featuring in the climate stress test of the Eurosystem balance sheet that is being planned for Q1 2022.

ECB vice president Luis de Guindos said, “Without policies to transition to a greener economy, physical risks will increase over time. They will increase non-linearly, and due to the irreversible nature of climate change, this increase will continue over time. It is essential to transition early on and gradually, so that we can mitigate the cost of both the green transition and the future impact of natural disasters.”

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