Exposure of banks to climate risks

The ECB is preparing to assess banks' exposure to climate risks, before banks in turn examine the climate risk of their customers.

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Towards integrating climate risk into the ECB's prudential requirements

Luis de Guindos, Vice President of the European Central Bank (ECB), alerts on the climate risks that would threaten companies and banks, in case climate policies are not up to the challenges. For businesses, these climate risks will lead to higher costs and/or lower profits, which could even lead to bankruptcy.

In the line of sight, if the ECB continues its work on climate risk, one can imagine that the prudential requirements imposed on banks - in particular the minimum amount of capital they must hold - will incorporate a “climate” component. Prudential leverage is also one of the areas identified in the European Commission's Sustainable Finance Action Plan, to explore how the regulator could use the obligations imposed on banks to promote the transition of the economy to a low-carbon model.

Following the 2008 financial crisis, the leaders of the eurozone decided to create a banking union, in addition to the monetary union in force since the creation of the euro.

This banking union is reflected in particular in the implementation of two pillars:

the Single Supervisory Mechanism (SSM), which ensures the supervision of banks,
the Single Resolution Mechanism (SRM), which ensures the orderly management of a possible bank failure.

Supervision of banks in the eurozone, a challenge at European level

As part of the SSM, the ECB is carrying out, among other things, stress tests (stress tests) to assess the ability of banks in the eurozone to withstand financial and economic shocks. The results of these tests allow the European Central Bank to identify the most vulnerable banks and to put in place the necessary measures to strengthen them, in cooperation with the banks concerned and the national supervisory authorities (example: the Banque de France).

As a reminder, the objectives of European banking supervision are as follows*:

Ensuring the solidity of the European banking system,
strengthening integration and financial stability,
Ensuring the consistency of banking supervision across the eurozone.

The ECB is concerned with a new type of risk: climate risks

Beyond traditional financial risks (credit risk, liquidity risk, etc.), in 2021, the ECB conducted a first climate stress test for the entire European economy.

This test focused on studying the impact of two climate risks on businesses and banks: physical risk and transition risk (a third** type of climate risk, liability risk, is set aside in this analysis).

As a reminder, here are the definitions given by Finance For Tomorrow***:

the Physical risk corresponds to the direct losses associated with the damage caused by climate hazards on economic actors (examples: increase in the frequency of extreme climate events - heatwaves - and occurrence of chronic events - long-term increase in temperatures and sea level),
the Transition risk corresponds to the economic consequences caused by the implementation of a low-carbon economic model (examples: new regulations, consumer behavior, technological innovations, etc.).

To do this, the ECB has compiled several types of information:‍

‍Different climate scenarios and economic trends by 2050, produced by a group of the world's largest central banks and supervisors, who are working on the development of green finance and the role of central banks in climate change**** (NGFS).

o A scenario of orderly transition and early (as early as 2020) thanks to a reduction in emissions compatible with a 2.0°C trajectory, involving progressive climate policies.

o One disorderly transition based on a late (2030) and abrupt introduction of aggressive climate policies to reach the 2.0°C objective.

O The Business as usual where no additional measures are taken and the increase in emissions leads to a warming of at least 3°C in 2080.‍

‍Climate data covering businesses and banks and making it possible to deduce their exposure to climate risks - climate score, carbon score. This data concerns more than 4,000,000 companies (financial statements, CO2 emissions, location of sites, etc.) and 2,000 banks (level of sectoral and geographical exposure).

Conclusions that call for an orderly transition to limit climate risks

The ECB considers that an orderly transition scenario is preferable to the other two scenarios in order to limit the impact of climate risks on the economy.

In this scenario where climate policies are rapidly and progressively strengthened, the initial cost of adapting to these measures would be largely offset by a lower cost of physical risk in the medium and long term, compared to other scenarios.

The logic is as follows: invest early in the transition to limit climate change and its negative medium/long-term impacts on the economy.

In addition, the ECB study highlights the geographical and sectoral heterogeneity of climate risk, by noting that the most polluting companies and those located in the regions most exposed to physical risk (heatwaves and fires in southern Europe, floods in northern Europe, etc.) are significantly more exposed to climate risks (up to 4 times).

Towards greater consideration of climate risk by banks and supervisory authorities

The ECB will continue its work and complement these initial results, in particular by examining the impact of climate risk at the level of each bank to identify individual vulnerabilities.

Climate risk is currently poorly integrated into the risk models of banks that provide financing to governments, businesses and individuals. However, while political leaders, organizations and citizens are increasingly concerned about the climate emergency, the financial sector is moving towards better taking these issues into account.

Beyond the initiatives taken by credit institutions in favor of financing Green (to mitigate and adapt to climate change) or the exit of the activities that emit the most CO2 (coal), banking supervision could soon analyze the solidity of banks in terms of their exposure to climate risks.

Following this logic, the next step should see banks manage their climate risks, in particular by reducing their exposure to client companies that are too risky from a climate point of view (physical risk or transition risk).

The solution for businesses: understanding and evaluating their climate risk

For businesses, it is therefore crucial to measure their exposure to climate risks now, in order to prepare for changes in bank policies, which will gradually integrate the climate dimension into their commercial strategy.

La first step is to measure your greenhouse gas emissions (GES) for Understand your transition risk. Thus, a company that emits very CO2, likely to be penalized by new regulatory constraints, could trigger the necessary changes before seeing banks turn away from it.

At Keewe, we provide our customers with the digital tool Carbon Photo, for an initial assessment of your CO2 emissions or to establish your Regulatory GHG balance.