ECB and ESRB published a report that look at how a broadened set of climate change drivers affect millions of global firms and thousands of financial firms in EU. The report maps out prospective financial stability risks and contributes by further developing the analytical basis for more targeted and effective policy action. The report tackles measurement gaps and, building on the previous work in this field, establishes a detailed topology of physical and transition risks arising from climate change across regions, sectors, and firms. It applies scenario analysis with long-dated financial risk horizons to capture the prospective financial losses resulting from the insufficiency in timeliness and effectiveness of climate policies and technologies.
The report explores three climate scenarios drawn from the Network for Greening the Financial System (NGFS). The scenarios were translated into actionable form by leveraging the granular risk mapping and transposing macroeconomic model outputs to 55 economic sectors and numerous regions. The scenarios were then run through stress test models for banks, insurers, and investment funds. The results suggest credit and market risks could increase as a result of a failure to effectively counteract global warming. The banking sector credit risk losses under adverse climate scenarios could amount to 1.60 to 1.75% of the corporate risk-weighted assets in a 30-year timeframe. Such a magnitude is nearly half that of the adverse scenarios used in conventional macroeconomic stress test exercises. Market risk losses could also be relevant for EU investment funds. Adverse scenarios suggest a direct aggregate asset write-down of 1.2% in holdings of equity and corporate bonds in the next 15 years.
Overall, the report finds that impacts of climate change on financial stability hinge on both the distribution of financial exposures and the evolution of prospective financial system losses. A granular mapping of financial exposures to climate change drivers suggests uneven vulnerability across EU regions, sectors, and financial institutions. Based on the granular mapping of financial exposures to climate change drivers, the report finds three forms of risk concentration:
- Exposures to physical climate hazards concentrated at regional level. The analysis shows that river floods will be the most economically significant widespread climate risk driver in EU over the next two decades; this is compounded by a strong vulnerability to wildfires and heat and water stress in some regions. Nearly 30% of the euro area banking sector’s credit exposures to non-financial companies are to firms that are subject to a combination of these physical hazards.
- Exposures to emission-intensive firms concentrated across and within economic sectors. Exposures to highly emitting firms occupy 14% of collective euro area banking sector balance sheets. While mainly concentrated in the manufacturing, electricity, transportation, and construction sectors, the exposures vary considerably within sectors—suggesting scope for financial market repricing as widely varying emissions intensities narrow.
- Exposures to climate risk drivers concentrated in financial intermediaries. Nearly 70% of banking system credit exposures to firms subject to high or increasing physical risk over the coming decades are concentrated in the portfolios of just 25 banks. At the same time, scope for financial market repricing associated with transition risk will be particularly large for investment funds, where more than 55% of investments are tilted toward high emitting firms and estimated alignment with the EU Taxonomy stands at only 1% of assets. While direct holdings by insurers of climate sensitive assets may be manageable, risks could be amplified by cross-holdings of investment funds of around 30%.
The report concludes that much remains to be done, despite the progress made in measuring and assessing the impacts of climate change on financial stability. A high degree of measurement uncertainty continues to hamper a fully accurate assessment of granular exposures to climate risks level. In terms of data, the sufficiency of reported information—including commonly agreed physical risk indicators and accurate transition risk indicators—remains a key issue, concerning both data availability and quality. For the moment, recourse to private data providers is essential to fill the existing gaps. In time, ongoing official sector initiatives in Europe and in global standard-setting bodies alike to shore up disclosures, standards, and taxonomies should go a long way in addressing outstanding issues. It will be essential to have consistent climate-related data, including ways to assess credible forward-looking Paris-alignment commitments, to develop efficient market mechanisms. As far as modeling is concerned, incorporating second-round effects, prospective non-linearities, value chain impacts and adaptation/risk mitigation measures would further enrich results. Empirical advances to date have been laying the foundations to inform nascent analysis on evidence-based policy—analysis that will benefit from continued momentum in the monitoring of climate risks to financial stability in EU.
Keywords: Europe, EU, Banking, Insurance, Securities, Climate Change Risk, ESG, Credit Risk, Market Risk, Scenario Analysis, Stress Testing, AnaCredit, Four Twenty Seven Data, ECB, ESRB
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