Climate change has the potential to cause substantial disruption to our economies, businesses and livelihoods in the coming decades. Yet the associated risks remain poorly understood, as climate shocks differ from the financial shocks observed during previous crises.
Climate
change occurs slowly over long periods, which creates significant
uncertainty about how extreme climate events will materialise in the
future. Both public and private institutions have a great deal of work
ahead of them to effectively identify and assess the potential impact of
these risks given that the traditional risk management tools may not
suffice. With this in mind, the ECB has designed the first economy-wide
climate stress test to help both authorities and financial institutions
assess the impact of climate risks on companies and banks over the next
30 years.
Typically, climate change risks are split into two broad categories.
The first is physical risk, which stems from the expected increase in
the frequency and magnitude of disasters caused by natural hazards.
Businesses located in exposed areas, for example close to rivers or the
seashore and therefore prone to flooding, could suffer significant
damage should a climate event occur. This damage could interrupt the
production process in the short term and potentially lead to business
failure in the longer term. Physical risks differ across countries and
regions, with southern Europe on average more susceptible to heat stress
and wildfires, while central and northern Europe are more vulnerable to
flooding.
The second category is transition risk, where the delayed or abrupt
introduction of climate policies to reduce CO2 emissions could have a
negative impact on certain energy and carbon-intensive industries, such
as mining, cement or steel. Higher tax rates on carbon usage could, for
example, increase production costs and reduce profitability.
Both physical and transition risks can harm financial stability if
banks or other financial institutions are exposed to defaulting firms
through their lending or asset holdings. Yet while it is common to
distinguish between the two types of risk, in truth they are
intertwined. Greater climate policy action may increase the impact of
transition risks in the near term while simultaneously reducing the
incidence of physical risks in future decades. The ECB climate stress
test captures and quantifies this potential trade-off using a 30-year
timeline to take account of the long-run impact.
The ECB climate stress test examines the resilience of companies and
banks to a range of climate scenarios. These scenarios set out
plausible representations of future climatic conditions while also
accounting for the impact on businesses of measures taken to limit the
extent of climate change, such as carbon taxes. The ECB scenarios are
based on those provided by the Network for Greening the Financial System
but have been adjusted to capture the relationship between transition
risk and physical risk more thoroughly.
The orderly scenario considers the timely and effective
implementation of climate policies which successfully limit global
warming. The hot house world scenario considers the impact if no new
climate policies are implemented and is associated with a very
significant increase of physical risk in the medium to long run. The
disorderly scenario considers the impact of a delayed and abrupt
implementation of climate policies.
These scenarios, together with a unique dataset that identifies and
quantifies transition and physical risk exposures for millions of
companies worldwide, provide the background for analysing the impact of
climate change on businesses and banks.
Preliminary results 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 our
economies, businesses and livelihoods.
ECB
© ECB - European Central Bank
Key
Hover over the blue highlighted
text to view the acronym meaning
Hover
over these icons for more information
Comments:
No Comments for this Article