Climate policies needed to prevent economy-wide defaults, ECB finds

Extreme weather events will substantially increase the probability of defaults in the absence of further climate policies, the European Central Bank (ECB) has concluded as part of its first economy-wide stress test on the long term effects of climate change. 

At the same time, the ECB has acknowledged that an introduction of green policies would cause a similar rise in defaults due to higher compliance costs. However, it claims this increase will be more than offset in the medium- to long- term by reducing the expenditure needed to cover physical risk.

With regards to the physical impacts of climate change, ECB noted that companies in Southern Europe were more susceptible to heat stress and wildfires, while those in middle and northern European countries had higher exposure to flooding risk. For transition risks – the costs associated with changes in technology, consumer preferences and regulation as the economy moves toward a low-carbon model – firms operating in carbon intensive sectors were identified as the most vulnerable.

The most polluting companies and those located in regions most exposed to physical risks from climate change could face “up to four times as much climate risk as the average firm over the next 30 years”, the ECB said.

The central bank’s findings are based on the preliminary results of a climate stress test involving four million companies worldwide and 2,000 Euro-area banks over a period of 30 years. It is the first ECB study to assess the climate risk exposure of euro area banks based on the resilience of their clients, and the first to use such a lengthy time horizon.

Stress tests are a key supervisory tool used to investigate how bank liquidity and capital would be impacted under a number of severe – but plausible – future scenarios as defined by regulators, and are increasingly being used to assess the threats posed by climate change.

 A total of three scenarios were modeled by the ECB, based on a framework released by central banking group the Network for Greening the Financial System. These were: an orderly transition to a low-carbon economy with early implementation of green policies, a disorderly transition with high costs due to delayed policy implementation, and a ‘hot house world’ with low transition costs but extremely high costs from physical damage caused by climate change. 

The exercise leveraged an “unprecedented dataset constructed by the ECB” covering the carbon footprint of millions of firms worldwide, combined with data on bank exposures and climate data from Four Twenty Seven. Supervisory stress tests have in the past relied on self-reported data from financial institutions.

With the release of the preliminary analysis focusing on company resilience, the ECB will now examine how changes in firm-level impacts will translate into bank-level exposure to climate risk through their loan books, and security and equity holdings. The full set of results are expected to be delivered by mid-2021.

It comes as ECB and Dutch central bank board member Frank Elderson reportedly indicated that the ECB will be increasing capital requirements for risky banks. However, he said that higher capital requirements solely based on climate risks are not anticipated to be introduced in the short term as “these decisions take time and are controversial”.

Separately, the EU’s trio of financial regulators has backed the use of  a mandatory reporting template for future asset manager disclosures under the Sustainable Finance Disclosure Regulation. The bodies, known collectively as the European Supervisory Authorities, were responding to Commission proposals setting out an 18-point disclosure framework on harmful investment impacts which are due to come into force early next year.