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ECB finds banks lack stress tests for assessing climate risk

08 July 2022 Amena Saiyid

Just two in five European banks have climate risk testing frameworks in place, but fewer than half are currently using the results of those tests to drive their business strategies, the European Central Bank (ECB) said 8 July.

Announcing the results of the central bank's "first-ever climate stress tests," the ECB said just 19% of the banks that already have climate stress test frameworks are using it to inform their loan granting process.

The ECB, which crafts, manages, and implements the EU's economic and monetary policy, said the test results show 41.35% of the 104 participating banks have incorporated climate risk testing frameworks, while 58.65% lack them.

Eurozone "banks are far from where we need to be," ECB Supervisory Board Vice-Chair Frank Elderson said in a video message on Twitter. But, he added, "we expect banks to take decisive action and develop robust climate stress-testing frameworks in the short to medium term."

ECB released the results four days after it announced steps to decarbonize its monetary policy operations.

Failure to disclose climate risks

The outcome of the climate stress tests complements what the ECB uncovered in March about climate risk assessment and disclosure in the financial sector. At least three-quarters of European banks are failing to disclose the material impact of climate and environmental risks to the global financial system, even though half of them have acknowledged exposure to such risks, it said.

Climate change and the transition to net-zero carbon emissions pose risks to households and firms, and, therefore, to the financial sector. Accordingly, ECB said, exposure to climate-related and environmental risks is among the ECB's banking supervision unit's strategic priorities for the 2022-24 period.

The results of the climate stress tests will complement a "thematic" review that the ECB said it is conducting in parallel to assess the progress banks are making to improve climate-related and environmental risk management.

Environmental advocates told Net-Zero Business Daily by S&P Global Commodity Insights that the ECB climate stress test results show that Eurozone banks that do not have a framework in place clearly face substantial exposure for failing to account for the physical risks they face through droughts, floods, and heat waves in countries where they are investing.

The results "validate the serious concerns that climate campaigners and progressive investors have been expressing for years—that financial institutions urgently need to raise the bar when it comes to assessing and incorporating climate and energy transition risks into their lending decisions," wrote Arjun Flora, energy finance studies director for Europe at the Institute of Energy Economics and Financial Analysis, in an 8 July email.

Heavy reliance on carbon-intensive industries

According to the ECB, banks generate 65.2% of their income from interest on loans to GHG-intensive sectors including real estate, energy, and agriculture.

"While banks continue to rely on carbon-emitting sectors for income," Flora said, "they are ultimately gambling with our collective future and ignoring the clear and tangible long-term value that would be created through a planned, accelerated transition to a sustainable economy."

The ECB is one of 114 central banks and financial supervisors across five continents that now make up the Network for Greening the Financial System (NGFS) that have voluntarily come together to share best practices on climate and environmental risk management. In late December, the NGFS issued a "how to guide" for central banks on assessing and disclosing climate risk across their own operations, as well as for the financial systems they oversee.

Ability to assess, respond to climate risks

Elderson said the ECB looked at the banks' ability to "analyze, assess, and respond to climate-related and environment stress."

Banks are exposed in varying degrees to the material effects of acute physical risks in Europe through droughts, extreme heat events, and floods. The risks banks face are closely linked to the geographical location of their lending activities that could in some cases lead to what the ECB said are "non-negligible losses."

As part of its climate stress-testing exercise, ECB asked banks it oversees to provide information on their climate-stress testing capabilities, reliance on carbon-emitting industries, and performance under different climate scenarios. The last "bottom-up stress test," directed at 41 banks that the ECB directly supervises, revealed that climate-related losses in the next three years could amount to €70 billion ($71.14 billion).

ECB acknowledged that the estimate understates the actual losses, owing to lack of data and weaknesses in modeling. Moreover, it said the underestimation failed to account for economic downturns and covered only a third of the banks' total balance sheet exposure.

Climate action plan

ECB said the test, which is part of its broader climate agenda, was not "a capital adequacy exercise but rather a learning one for banks and supervisors alike."

In mid-June, the Basel Committee on Banking Supervision, the primary global standard-setting organization for central banks including the ECB and the US Federal Reserve System, published 18 "Principles for the effective management and supervision of climate-related financial risks."

In these principles, the Basel Committee encouraged central banks to develop a process to understand and assess the potential impacts of climate-related risk drivers on their businesses and, more importantly, the environments in which they operate. It also said central banks should consider and plan for material climate-related financial risks beyond their business-as-usual, two-to-three-year planning horizons and fold them into their overall business strategies and risk management frameworks.

In April 2021, the Basel Committee said uncertainty about the nature of climate change and lack of data, especially from banks, hinders the ability of central banks to estimate and quantify the risk that climate change poses to the financial system.

Moving away from carbon-intensive industries

In addition to its supervisory role, the ECB is taking steps to align its monetary policy operations with the EU goal of achieving net-neutrality by mid century.

On 4 July, the Governing Council of the ECB said it would gradually lessen its reliance on high carbon-emitting industries in corporate bond holdings as early as this October, and start issuing quarterly reports on the climate-related information of its corporate bond holders in the first quarter of 2023.

By the end of 2024, the ECB also will limit the shares of high carbon assets that companies can use as collateral. Initially, this limit will be applied to non-financial corporations, but will expand to other asset classes, such as market debt instruments issued by financial institutions and bank loans and credit claims. In the interim, ECB officials said it would engage in test runs across asset classes to prepare them for the upcoming limits.

Moreover, the ECB said it will give greater weight to companies that are complying with the EU's Corporate Sustainability Directive, once it has been implemented. ECB expects that to happen by 2026.

The ECB said it is consciously "tilting" towards environmental, social, and corporate governance (ESG) via its reinvestments of the corporate sector purchase programme (CSPP), which amounts to €30 billion ($30.52 billion) a year, or just slightly more than 10% of the bank's corporate portfolio.

Given the importance of considering and aligning financial activities with climate impacts, "the ECB steps are very welcome," Jurie Yada, program lead for EU sustainable finance with thinktank E3G, told Net-Zero Business Daily 8 July.

Yada said these steps give the "right regulatory signals" to the market and will put pressure on "companies to consider and move towards lower emission transitions in their activities in order to qualify for bonds issuance."

Posted 08 July 2022 by Amena Saiyid, Senior Climate and Energy Research Analyst



This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.

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