July 26, 2022
- Climate risk shocks could spread across the financial system, especially in the event of a disorderly green transition
- Financial market losses due to an abrupt reassessment of climate risks could hit investment funds and insurers and trigger corporate defaults and bank loan losses
- Macroprudential and microprudential policies should work together to mitigate systemic risk
The European Central Bank (ECB) and the European Systemic Risk Board (ESRB) today published a joint communication report How climate shocks can affect the European financial system. The results show that climate risks can spread quickly and harm companies and banks alike. The report adds further evidence of the systemic nature of climate risks and provides a basis for a macroprudential policy response.
The report identifies multiple climate risk amplifiers across the financial system. Transition risks can be magnified due to economic and financial links between and between banks and corporations. For example, a rise in carbon prices could make it more likely that one company’s failure will lead to the failure of another. While this is particularly true for high-carbon companies, it could also affect their less-high-carbon counterparts.
Meanwhile, interdependent natural hazards — such as water stress, heat stress and wildfires — can compound physical climate risk as they can aggregate and reinforce each other. Market dynamics can also amplify the financial impact of physical risk. For example, a climate shock could lead to a sudden repricing of climate risk, thereby leading to fire sales, where financial institutions – especially those with overlapping portfolios – quickly sell large numbers of exposed assets at once at distressed prices.
Scenario analyzes suggest that climate risks could take shape in the financial system in a specific order. First, unforeseen climate shocks could have an abrupt impact on market prices, initially hitting the portfolios of mutual funds, pension funds and insurance companies. Second, this sudden repricing could lead to corporate defaults, which would result in losses for exposed banks. In a disorderly transition scenario characterized by an immediate and significant rise in carbon prices, insurers and investment funds could see respective short-term market losses of 3% and 25% on stressed assets. An orderly transition towards net zero by 2050 could cushion such shocks and mitigate the impact on businesses and banks by reducing the likelihood of corporate failures in 2050 by around 13-20% compared to today’s guidelines. It would also reduce credit losses for banks.
The report assesses the scope for macroprudential action as part of a broader policy response to the financial impact of climate change. It speaks for an adjustment of existing instruments, in particular systemic risk buffers or concentration thresholds. Such measures could complement efforts at the micro-prudential level, such as the ECB’s supervisory climate agenda, including the ongoing thematic review of climate risks and the 2022 climate risk stress test.
The report builds on two previous ECB/ESRB reports on climate risks. It is part of the ECB-wide climate agenda, which outlines all of our ongoing climate-related work, including efforts to improve climate risk assessment. This work includes an update of the 2021 economy-wide climate stress test as well as continuous monitoring of climate risk in the financial system.
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