The ECB published the results of its climate risk stress test

The ECB published the results of its climate risk stress test

On Friday 8 July, the European Central Bank (ECB) published the results of the climate risk stress test that was performed in the first half of this year. In total 104 banks participated in the stress test that was intended as a learning exercise, for the ECB and the participating banks alike. In this article we provide a brief overview of the main results.

The ECB’s goal with the climate risk stress test was to assess the progress banks have made in developing climate risk stress-testing frameworks and the corresponding projections, as well as understanding the exposures of banks with respect to both transition and physical climate change risks. The stress test therefore consisted of three modules: 1) a qualitative questionnaire to assess the bank’s climate risk stress testing capabilities, 2) two climate risk metrics showing the sensitivity of the banks’ income to transition risk and their exposure to carbon emission-intensive industries, and 3) constrained bottom-up stress test projections for four scenarios specified by the ECB1. The third module only had to be completed by 41 directly supervised banks to limit the burden for some of the smaller banks included in the climate risk stress test.

An understatement of the true risk

The constrained bottom-up stress test projections show that the combined market and credit risk losses for the 41 banks in the sample amount to approximately EUR 70 billion in the short-term disorderly transition scenario. The ECB emphasizes that this probably is an understatement of the true risk, because it does not consider the scenarios underlying the stress test to be ‘adverse’. Second round economic effects from climate risk changes have, for example, not been factored in. Furthermore, only a third of the total exposures of the 41 banks were in scope and, on top of that, the ECB considers the banks’ modeling capabilities to be ‘rudimentary’ in this stage: they report that around 60% of the banks do not yet have a well-integrated climate risk stress testing framework in place, and they expect that it will take several years before banks achieve this. Even though banks are not meeting the ECB’s expectations yet, the ECB does conclude that banks have made considerable progress with respect to their climate stress testing capabilities.

Be aware of clients’ transition plans

A further analysis of the results shows that the share of interest income related to the 22 most carbon-intensive industries amounts to more than 60% of the total non-financial corporate interest income (on average for the banks in the sample). Interestingly, this is higher than the share of these sectors (around 54%) in the EU economy in terms of gross added value. The ECB argues that banks should be very much aware of the transition plans of their clients to manage potential future transition risks in their portfolio. The exposure to physical risks is much more varied across the sample of banks. It primarily depends on the geographical location of their lending portfolios’ assets.

The ECB points out that only a few banks account for climate risk in their credit risk models. In many cases, the credit risk parameters are fairly insensitive to the climate change scenarios used in the stress test. They also report that only one in five banks factor climate risk into their loan origination processes. A final point of attention is data availability. In many cases, proxies instead of actual counterparty data have been used to measure (for example) greenhouse gas emissions, especially for Scope 3. Consequently, the ECB is also promoting a higher level of customer engagement to improve in this area.

Many deficiencies, data gaps and inconsistencies

The outcome of the climate risk stress test will not have direct implications for a bank’s capital requirements, but it will be considered from a qualitative point of view as part of the Supervisory Review and Evaluation Process (SREP). This will be complemented by the results from the ongoing thematic review that is focused on the way banks consider climate-related and environmental risks into their risk management frameworks. The combination will indicate to the ECB how well a bank is meeting the expectations laid down in the ‘Guide on climate-related and environmental risks’ that was published by the ECB in November 2020.

The ECB notes that the exercise revealed many deficiencies, data gaps and inconsistencies across institutions and expects banks to make substantial further progress in the coming years. Furthermore, the ECB concludes that banks need to increase customer engagement to obtain relevant company-level information on greenhouse gas emissions, as well as to invest further in the methodological assumptions that are used to arrive at proxies.

If you are looking for support with the integration of Environmental, Social, and Governance risk factors into your existing risk frameworks, please reach out to us.

Notes
1) See our earlier article on the ECB’s climate stress test methodology for more details.