ECB Article Describes Framework for Economy-Wide Climate Stress Test

The article points out the innovative components of this economy-wide climate stress test from ECB. Preliminary results of the economy-wide test show that, in the absence of further climate policies, the costs to companies arising from extreme events increase substantially. The results also show that there are clear benefits in taking action early: the short-term costs of adapting to green policies are significantly lower than the potentially much higher costs arising from natural disasters in the medium to long term. Climate change thus represents a major source of systemic risk, particularly for banks with portfolios concentrated in certain economic sectors and geographical areas. These results underline the crucial and urgent need to transition to a greener economy, not only to ensure that the targets of the Paris Agreement are met, but also to limit the long-run disruption to economies, businesses, and livelihoods.

ECB plans to take a number of further steps to broaden and strengthen these preliminary results. First of all, the firm-level impact will be used to assess banks’ resilience to climate risks through loans, security, and equity holdings. The full set of results will be available by mid-2021, including how changes in firms’ solvency translate into changes in bank-level vulnerability to transition and physical risks. The exercise will include more than 2,000 consolidated banking groups, covering almost all banks in the euro area. The current framework will then be extended to include a more dynamic response by banks to climate change. In particular, the decline in the creditworthiness of certain firms could incentivize banks to adjust the composition of their portfolios, shifting their investments toward less risky firms. Those changes in bank exposures could trigger second-round effects on the real economy, for example, through investment demand. The current framework will be expanded to consider these dynamics in the second half of 2021. Finally, the impact on the portfolios of non-banks such as asset managers and insurance companies will also be considered to arrive at a comprehensive view of the impact of climate change on the entire financial sector. 

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Keywords: Europe, EU, Banking, Climate Change Risk, Stress Testing, Systemic Risk, ESG, ECB