ESRB published a report that explores the quantitative perspectives on financial stability risks stemming from climate change and examines how the information gap can be filled for the euro area and EU member states. The report proposes foundations for the required risk monitoring, along with the initial elements underpinning a pilot risk assessment framework for banks and insurers. The report also highlights that the ongoing health pandemic has brought the prospect of large shocks to our collective attention and has laid bare the need for timely information as the shock evolves. Considering this need, the report also identifies areas where further work is needed to improve measurement, thus enabling a more complete evaluation of the risks associated with climate change.
The report draws insights from granular supervisory datasets based on available carbon emissions reporting and makes use of existing economic and financial models to gauge potential near-term risks. While climate change reporting by banks and firms alike remains patchy, available datasets and methodologies nonetheless already shed considerable light on financial stability risk exposures. The report outlines the evidence on costs of climate change and examines whether financial markets are pricing climate-related shocks or building capacity to do so in the future. It then discusses financial-sector exposures and presents details on the forward-looking scenario analysis and the foundations of an exploratory pilot risk assessment framework. The following are the key findings of the analysis:
- Costs associated with climate change appear inevitable. There will either be physical costs resulting from an insufficiency (or lack of timeliness) of mitigating action or transition costs from stringent action—or both.
- Financial markets only price risk in a limited way. Despite the incomplete, inconsistent, and insufficient data, green capacity is building rapidly in bond, equity, and emissions trading.
- Drawing on the available supervisory reporting of large exposures of banks, the analysis concludes that direct exposures of European financial institutions to CO2-intensive sectors appear to be limited and falling moderately on average, but with tail risk in the form of concentrated exposures in a few sectors and firms.
- With respect to the forward-looking exploratory scenario analysis, a review of the transition risk scenarios suggests that costs, to the economic or banking sector, of even a sharp rise in carbon pricing or marked industrial shifts over a five-year timeframe are likely to be contained and lower than for the potential losses due to physical risks resulting from climate change. The forward-looking exploratory scenario analysis builds on the methodology developed by DNB and in the ECB banking sector euro area stress test (BEAST) banking model.
Regardless of the foundations that this report provides for better understanding financial stability risks arising from climate change, further work is needed for more accurate and encompassing measurement of the risks to financial stability. Data gaps constrain a fully representative analysis while disclosures remain incomplete, inconsistent, and insufficient. Due to their voluntary nature, firm disclosures of climate metrics remain partial and incomplete amid likely selection bias and are, therefore, not representative of the broader industrial sample of polluting firms. Inconsistency relates to the potential for “greenwashing,” with an inadequate accreditation for green labeled products in the absence of a widely accepted benchmark taxonomy. Insufficiency relates mainly to the downstream emission intensity of the products of portfolios, which are rarely reported in a consistent manner. Additionally, disclosures of financial institutions—notably banks—fail to encompass the climate risk inherent in their asset portfolios. Newly available credit register information might help to fill gaps.
Financial-sector exposures and vulnerabilities to climate change currently involve an eclectic collection of existing supervisory data, market data sources and other data. As a way forward, once more comprehensive granular data are available, the opportunities created as a result, for example from credit registers, should be explored. Climate risk measurement could also be improved. Additional data collections may be needed to supplement existing firm disclosures, which are patchy and at times heterogeneous. With regard to methodological investments, more climate-specific modeling (including long-term stress testing for banks and insurers) is needed. Ultimately, analysis of systemic risks from climate change should provide the foundations for evidence-based macro-prudential policy reflections. At a minimum, further work is needed to better frame disclosure needs to help address informational market failures associated with climate-change risk, thus providing a basis for effectively addressing the allocative market failures associated with climate change.
Related Link: Report (PDF)
Keywords: Europe, EU, Banking, Insurance, Securities, Climate Change Risk, Financial Stability, ESG, Sustainable Finance, Systemic Risk, Stress Testing, Disclosures, Reporting, Basel, ECB, ESRB
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