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On 22 September 2021, the European Central Bank (“ECB”) released a report on its top-down economy-wide climate stress test. Flooding in Belgium, France and Germany in July, forest fires in Greece in August or the never-before-seen rainfall in Greenland at 3,000 m above sea level are concrete examples of climate change, all occurring over the last three months. The question therefore is no longer if and when climate change will affect the real economy but rather how severe the impact will be.
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Climate change risk

Climate change is one of the most prominent challenges the world must address in the 21st century.  The 16th edition of the Global Risks Report released in early 2021 by the World Economic Forum [1] pointed out that extreme weather, climate action failure, human environmental damage and biodiversity loss represented 4 of the Top 5 global risks by likelihood. As a result, it is imperative that financial institutions and non-financial corporations take measures to manage these impacts.

Emerging source of systemic risk

The ECB economy-wide climate stress test exercise was conducted to assess transition risk. Reducing carbon emissions and facilitating the transition to a greener economy will create risks for industries heavily reliant on non-renewable or highly polluting resources, resulting in a fall in profits and higher production costs.

The exercise also addressed physical risk, which refers to the impact on the economy of more frequent and more severe climate-related events if policies to mitigate climate change and meet the Paris Agreement targets are not introduced and applied. Transition risk and physical risk represent an emerging source of systemic risk having the potential to disrupt the provision of services by banks as well as to affect the functioning of financial markets, in turn leading to impacts on the real economy.

3 scenarios

In that context, the ECB conducted an economy-wide climate stress test that assesses the resilience of 4 million Non-Financial Corporations (NFCs) and 1,600 consolidated banking groups in the Eurozone. The goal of the exercise was to measure how banks’ liquidity position and solvency would be affected under three severe yet plausible scenarios.

The first scenario (best-case scenario) considers that climate policy measures are well calibrated and implemented in a timely and effective way resulting in limited costs deriving from transition and physical risks. This scenario considers that the targets set in the Paris Agreement in 2015 will be met. On the opposite side, the second scenario (worst-case scenario) considers that no regulation nor policy aiming at limiting climate change will be introduced. This would translate to a global temperature increase, from now until the year 2100, of more than 3 degrees Celsius above that of pre-industrial levels. This is opposed to the 1.5 degree Celsius target under the Paris Agreement. The third scenario is an in-between best and worst-case scenario, assuming a delay in implementing climate change actions.

NFC’s first, Banks as a second step

The climate stress test evaluates firstly the resilience of NFCs to transition and physical risks and ultimately estimates how their potential default would be affected under the scenarios’ assumptions, based on granular information on individual firms' carbon footprint and their vulnerability to physical risk.  The modelling of the scenarios assesses how climate risk drivers will affect balance sheet and profitability indicators of NFCs taking also into consideration amplifiers and mitigants.

In a second phase, the stress test measures the impact of climate risk on the Eurozone banking system through credit risk and market risks. Under the credit risk channel, the changes in the probability of default and loss given default of the banks’ loan book is calculated under each climate scenario to quantify the impact on credit risk.  The results provide evidence of the benefits of timely and orderly implementation of climate-related measures. As stated in the ECB report, “the short-term costs of a green transition are more than compensated by the long-term benefits, while physical risk tends to prevail in the medium to long run if climate policies are not implemented.”  Under the market risk channel, the impact on banks’ corporate securities is captured by the sensitivity of the price of bonds. 

Findings

The results of this exercise demonstrate firstly that the earlier we act, the higher the benefit will be in terms of managing risks. The costs of a timely and ordered transition would, in the medium to long run, be much lower than the one resulting from a climate change more severe than forecasted in the Paris Agreement. In addition, the results show that even if the effect of climate risks rise moderately, should climate change not be mitigated, they would be concentrated in certain geographical areas and in some specific sectors. The results also show that in the absence of climate policies, NFCs and credit institutions could suffer from a very significant adverse impact. Finally, and importantly, the impact on banks’ solvency is mainly driven by physical risk and could potentially be severe as they will face higher expected losses if climate risks are not mitigated under a timely and orderly transition.

Future developments

Banking supervision has announced a thematic stress test on climate risks in 2022 to analyse in detail banks’ internal stress-testing practices and to increase knowledge and understanding of climate risk. Also, the methodology will be updated to incorporate the new “Network to Greening the Financial System” scenarios published in June 2021 and a shift from static balance sheet assumption to dynamic balance will be implemented to allow for second round effects. Ultimately, the methodology may be expanded to incorporate the effects of transition and of physical risks on banks’ retail portfolio and the impact on other financial intermediaries (asset managers and insurance companies).

How can Grant Thornton Luxembourg help you?

  • Our team of experts in Financial Regulation, Governance, Sustainability and ESG can assist you to:
  • Adapt internal stress-testing practices for climate and transition to prepare for the 2022 thematic stress test.
  • Raise awareness of the management body and staff on ESG matters, including climate and transition risks.
  • Review current practices, identify gaps and achieve compliance with Sustainable Finance regulatory requirements.
  • Align your strategy and risk management in accordance with ESG considerations.
  • Adopt a continuous monitoring and reporting framework.

 

For more information, please contact our experts:

 

[1] http://www3.weforum.org/docs/WEF_The_Global_Risks_Report_2021.pdf