The ECB’s stress test shows that most banks do not include climate risk in credit models
Environmental protesters take to the streets during a demonstration of Fridays for Future in the financial district of Frankfurt, Germany, in August last year.
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The results of the European Central Bank’s first stress test for climate risk show that most euro area banks do not adequately incorporate climate risk into their stress stress frameworks and internal models.
In a report published on Friday, the ECB said that the findings confirm the view that banks must sharpen their focus on climate risk.
It comes at a time of strong heat and little rainfall in southern Europe, rising energy prices and the prospect of a halt to the region̵[ads1]7;s gas supplies from Russia in retaliation for the sanctions imposed due to the Kremlin’s attack on Ukraine.
To be sure, the world’s leading climate scientists have warned humanity has reached “now or never” territory to avert the worst of what the climate crisis has in store.
“Eurozone banks must urgently step up their efforts to measure and manage climate risk, close current data gaps and adopt good practices already in place in the sector,” said Andrea Enria, chair of the ECB’s Presidency, in a statement.
A total of 104 banks participated in the test, which is the first of its kind, the ECB said, providing information on three modules, or categories. These included their own capabilities for climate stress testing; their dependence on carbon emissions sectors; and their performance under different scenarios over multiple time horizons.
The results from the first module found that approximately 60% of the banks do not yet have a framework for stress testing of climate risk.
Similarly, the ECB said that most banks do not include climate risk in their credit risk models and only 20% consider climate risk as a variable when granting loans.
Regarding the banks ‘dependence on carbon emissions sectors, the ECB said that in total almost two thirds of the banks’ income from non-financial corporate customers comes from greenhouse gas-intensive industries.
In many cases, the report found that banks’ “financed emissions” come from a small number of large counterparties, which increases their exposure to emissions-intensive sectors.
Within the third module, the results were limited to 41 banks under direct supervision to ensure proportionality towards smaller banks. It required lenders to project losses in extreme weather events under different transition scenarios.
The results warned that credit and market losses could total around 70 billion euros ($ 70.6 billion) this year for the 41 directly supervised banks.
However, the ECB noted that this “significantly underestimates the actual climate-related risk”, as it only reflects a fraction of the actual hazard. This was partly due to a lack of available data.
“This exercise is a crucial milestone on our path to making our financial system more resilient to climate risk,” said Frank Elderson, Deputy Chairman of the ECB’s Supervisory Board. “We expect the banks to take decisive action and develop robust frameworks for climate stress testing in the short to medium term.”
ECB President Christine Lagarde previously said that the central bank was taking steps to incorporate climate change “into our monetary policy operations”.
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The ECB said that it collected both qualitative and quantitative information, with a view to assessing the sector’s climate risk preparedness and gathering best practices for managing climate-related risk.
The report concluded that most banks would need to continue working to improve the stress structure framework’s governance structure, data availability and modeling techniques.
