The top five climate risk stories this week
1) EU bank losses from climate shocks could hit €70bn
European lenders face €70 billion of losses from an abrupt spike in carbon prices and a series of natural disasters, the results of the European Central Bank’s (ECB) first supervisory climate stress test show.
Officials say this figure may understate the true scale of the potential threat, however, because of gaps in banks’ climate data and modelling capabilities. The scenarios also excluded second-round effects, like a climate risk-related economic downturn.
Overall 104 banks took part in the climate stress test, which consisted of three modules. In the first, each bank submitted data on their own climate stress-testing capabilities. In the second, they disclosed the amount of income they generate from carbon-intensive borrowers. In the third, they calculated their performance under macro-financial scenarios covering short-term and long-term climate shocks.
The €70 billion loss figure includes credit and market losses projected under the short-term transition risk scenario and two physical risk scenarios — one covering flood risk and another drought and heat wave risk. Forty-one banks participated in this part of the ECB’s exercise, and only around one-third of their total exposures were subjected to the stresses. The short-term transition risk scenario assumed that carbon prices rise sharply in 2022, 2023, and 2024 and that the European Union economy grows more slowly as it grapples with the rapid shift to a net-zero emissions pathway.
Banks fared better under the long-term transition scenarios, the ECB reported. Firms were told to project losses over a 30-year horizon under ‘orderly’, ‘disorderly’, and ‘hot house world’ scenarios. The results showed that estimated losses are “notably lower” under the ‘orderly’ scenario.
The climate stress test also revealed that around 60% of banks still lack a climate risk stress-testing framework and that the majority do not include climate factors in their credit risk models. Furthermore, it found that on aggregate about two-thirds of banks’ income comes from carbon-intensive clients. This suggests a hefty chunk of their revenues are vulnerable to transition risks.
The ECB said the test results will have no bearing on bank capital requirements this year. However, all participants have been given individual feedback and are expected to respond appropriately in line with best practices the ECB will release in the final quarter of 2022.
“Euro area banks must urgently step up efforts to measure and manage climate risk, closing the current data gaps and adopting good practices that are already present in the sector,” said Andrea Enria, Chair of the ECB’s Supervisory Board.
2) ECB will ‘green’ its bond portfolio
The European Central Bank (ECB) said it will factor climate risks into its monetary policy operations in an escalation of its efforts to support the low-carbon transition.
The central bank announced on Monday that it would rejig its corporate bond portfolio by tilting future purchases toward climate-friendly assets. Bond issuers will be judged on their greenhouse gas emissions, the ambition of their carbon reduction targets, and the quality of their climate-related disclosures, the ECB said. The changes will be implemented from October this year.
Isabel Schnabel, an executive board member of the ECB, said the policy would affect around €30 billion of bond reinvestments each year, or about 10% of the bank’s overall corporate portfolio.
Banks and other financial institutions also face limits on the amount of carbon-intensive bonds they will be able to pledge as collateral with the ECB in exchange for cash loans from 2024. The ECB said this new regime would initially apply to bonds issued by non-financial companies, but could spread to additional asset classes in future. In addition, the bank said it would factor climate risks into its assessment of the haircuts applied to corporate bond collateral starting this year. Haircuts are discounts imposed on the value of collateral based on their riskiness.
Furthermore, only bonds issued by companies that comply with the European Union’s incoming Corporate Sustainability Reporting Directive — once it’s in force — will be eligible for inclusion in the ECB’s collateral framework.
3) Climate scenario analysis should not inform capital rules — trade bodies
Scenario analysis should not be used to gauge the capital adequacy of financial institutions in relation to climate-related transition and physical shocks, industry groups warned.
In a joint response to the Financial Stability Board’s consultation on supervisory and regulatory approaches to climate-related risks, the International Swaps and Derivatives Association (ISDA), the Institute of International Finance (IIF), and the Global Financial Markets Association (GFMA), said “the results of medium- or long-term climate scenario analysis exercises should be treated with caution and should not inform capital evaluations, particularly as there are more efficient tools available to incentivize and oversee financial institutions’ management of longer dated risks.”
The groups also said it would “not be appropriate” to use near-term climate stress testing to judge climate capital adequacy “as the foundations are not in place with respect to knowledge, data, and modelling.”
They further argued that the FSB “should not urge supervisors or financial institutions towards following a prescriptive approach to the expanded use of scenario analysis.” Instead they made the case for “collaborative development”, through which institutions and their overseers could bridge climate data and methodology gaps and enhance the comparability of different supervisory exercises.
The trade bodies also emphasized their opposition to the introduction of climate capital charges under the Pillar 1 prudential framework. “Given the nascent nature of the collective understanding of how climate risk drivers will impact existing risks, it seems premature to define a supervisory or regulatory capital treatment,” the groups said.
4) EU told to mandate transition plans for financial institutions
Banks and insurers should be required to produce low-carbon transition plans and targets, climate advocacy groups have said.
In an open letter to European Union policymakers, 13 climate-focused think tanks and non-profits argued that rules to this effect should be embedded in existing regulation.
“With its risk-based approach, the EU prudential regulatory framework for financial institutions needs targeted upgrades to ensure climate-related financial risks are dealt with … By integrating requirements for transition-planning and the related stewardship role, financial institutions can both mitigate risks and play a role of channelling financing at the same time,” the letter said.
The climate groups added that voluntary initiatives on transition plans and targets “have been proven ineffective”.
5) Few financial institutions have oil and gas plans
Over two-thirds of the world’s top financial institutions do not have an oil and gas policy, an analysis by climate-focused non-profits shows.
The Oil and Gas Policy Tracker (OGPT), first launched last year by French climate group Reclaim Finance and 16 other non-profits, today monitors 369 banks, insurers, and investors from 32 countries. The updated tracker finds only 136 institutions have oil and gas policies in place, and just 4% of firms have adopted rules concerning oil and gas expansion. This despite the fact that 158 of the institutions assessed are members of the Glasgow Financial Alliance for Net Zero, which was set up to support decarbonization of the financial sector.
French lender La Banque Postale is a top performer under the OGPT, having announced in October 2021 a plan to ban all companies with oil and gas expansion plans from its lending and investing activities.
“Despite [UN Secretary General] Antonio Guterres’ recent call on all financial institutions to abandon fossil fuel finance and invest in renewable energy, most banks, insurers and investors continue to support companies with ruthless expansion plans. The war in Ukraine and the heatwaves hitting Europe, India and Pakistan should be a violent wake up call and encourage all banks, insurers and investors to take real climate action and stop fueling a fossil-fuel based future,” says Lucie Pinson, director of Reclaim Finance.
