Climate change impact on European banks

The European Central Bank (ECB) released its “economy-wide climate stress test”, developed to assess the resilience of non-financial corporates and euro area banks to climate risks (transition risk and physical risk), under a range of assumptions in terms of future climate policies. The results show how climate change represents a major source of systemic risk, and how for corporates and banks most exposed to climate risks, the impact is potentially very significant. If climate risks are not reduced, the costs to companies arising from extreme weather events would rise substantially, and significantly and negatively affect their creditworthiness, increasing expected losses of banks credit portfolios.

The ECB´s climate stress test includes three scenarios with different economic impacts and therefore different expected losses of banks’ credit portfolios:

• Orderly transition scenario (or base scenario): it assumes that climate policies are well calibrated and are effectively implemented in a timely manner. Therefore, the physical and transition impacts are limited.
• Disorderly transition scenario: intermediate scenario that assumes a delay in implementing policies against climate change. The measures are implemented abruptly, which carries a high impact due to the risk of transition. The physical risk impact is also higher than in the orderly transition scenario.
• Hot house scenario: it assumes that no regulation is applied to limit climate change and therefore the physical risks are more extreme. In this scenario, there would be no costs for transition risk, but there would be large costs for physical risk.

The main conclusions of the exercise are the following:

• There are clear benefits to acting early. The short-term transition costs are clearly lower than those of climate change in the medium and long term. Luis de Guindos, Vice-President of the ECB said that “without policies to transition to a greener economy, physical risks will increase over time”.
• Climate change thus represents a major source of systemic risk, particularly for banks with portfolios concentrated in certain economic sectors (those most affected by a green transition such as mining, gas or electricity) and, more importantly, in specific geographical areas (those most affected by more severe and frequent natural disasters if climate change is not mitigated).
• The impact on banks in terms of losses would mostly be driven by physical risk. While most countries have similar average exposures to transition risk, banks’ exposures to physical risk greatly depend on their location. From the point of view of physical risk, 22% of European banking exposures would be exposed to high physical risk, mainly due to fires and heat waves that would affect southern European countries, with Spain being among the most affected.