The necessary transition to a low-carbon economy entails risks for the financial system. Correctly assessing these risks requires a higher quantity and quality of disclosures. The ECB is contributing to the development of an analytical framework for climate risk assessment, and developing methods to gauge exposures to climate-related risks on the balance sheets of financial institutions.
Climate change-related risks have the potential to become systemic for the euro area financial system, particularly if markets are not pricing the risks correctly. Rapid crystallisation of risks, or of market repricing, could lead to substantial disruption.
Recent analysis of the 12 largest banks and 14 largest insurers in the euro area shows that information on financial institutions’ climate-related risks is scarce and inconsistent. While a majority disclose the impact of their business travel, commuting and other energy usage, most of a financial institution’s exposure to climate-related risk likely stems from its financial activities. Only five of these large banks and insurers partially disclose the impact of their financial assets, and none of them provide full disclosure.
The ECB is carefully studying the potential impact of climate-related risks for the euro area financial system.
The ECB is currently developing an analytical framework for carrying out a climate risk stress test analysis for the euro area banking sector. The pilot test framework will be macroprudential in nature, and allow the ECB to analyse the system-wide materiality of transition risks for banks’ solvency, along with their lending capacity and the implications for the overall economy. The eventual aim is to incorporate both physical and transitional risks, and investigate how these two types of risks interact with each other.
This type of analysis still faces some major barriers. There is no consistent classification of firms’ activities and the data on banks’ exposures is not granular enough. The ECB expects this to improve, however, since banks clearly need to treat risks from climate change in the same fashion as other financial risks.
These stress tests analyses will be challenging to design and implement, but may greatly increase the knowledge about the financial impact of climate risks, environmental policy trade-offs and overall economic resilience.
Climate-related risks also represent a significant threat to prosperity in the economy more widely.
Governments must shoulder the greater part of the burden of driving the transition. Effective carbon taxes and cap and trade schemes, such as the EU emissions trading scheme, force companies and consumers to pay a more representative cost for their activities, and incentivise them to find the most efficient way to reduce emissions. Beyond carbon emissions, global solutions are needed to ensure polluting activity cannot arbitrage between jurisdictions.
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