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Positively green: Measuring climate change risks to financial stability

The ESRB report looked in detail at quantitative perspectives on climate-related risks to financial stability for the Euro area and the EU. It proposed foundations for the risk monitoring that is required, as well as initial elements underpinning a pilot risk assessment framework for banks and insurers. The report also detailed where further work is needed to develop better measurement, enabling a more complete evaluation of the risks associated with climate change.

European Systemic Risk Board – Report
8 June 2020
Source: European Systemic Risk Board

Report prepared jointly by the ESRB Advisory Technical Committee and Eurosystem Financial Stability Committee.
Drafted by Morgan Despres and Paul Hiebert (editors), Thomas Allen, Katarzyna Budnik and Rafel Moyà Porcel.

Positively green: Measuring climate change risks to financial stability

From the introduction:

Positive measurement of the impacts of climate change is needed to underpin an increasingly heated normative debate. In the sphere of financial stability, there is currently a dearth of sufficiently encompassing and reliable information on risks resulting from climate change. This report evaluates how this information gap can be filled for European Union (EU) Member States, leveraging existing data and methodologies. In particular, the report draws insights from granular supervisory datasets based on available carbon emissions reporting and makes use of existing economic and financial models to gauge potential near-term risks. While climate change reporting by banks and firms alike remains patchy, available datasets and methodologies nonetheless already shed considerable light on financial stability risk exposures. In this context, this report tackles four questions: (i) what magnitude of climate-related shocks can be expected?, (ii) are financial markets pricing the prospect of such shocks (or building capacity to do so in the future)?, (iii) what are the exposures of banks and insurers (based on available disclosures) to potential repricing of climate-related risk?, and (iv) what can we learn from forward-looking scenario analysis to determine where further investment is needed?

Conclusions, open issues and proposed way forward

This report looked in detail at quantitative perspectives on climate-related risks to financial stability for the euro area and the EU, leveraging available information and existing models. It proposed foundations for the risk monitoring that is required, as well as initial elements underpinning a pilot risk assessment framework for banks and insurers. In doing so, it presented measurement where possible – noting in particular a limited granular coverage of loans for banks. Mindful of the limitations of both available data and models, the report also detailed where further work is needed to develop better measurement, enabling a more complete evaluation of the risks associated with climate change.

Four findings emerge from the report. First, costs associated with climate change appear inevitable. There will either be physical costs resulting from an insufficiency (or lack of timeliness) of mitigating action, or transition costs from stringent action – or both. A second finding is that, to date financial markets only price this risk in a limited way. Notwithstanding data which are incomplete, inconsistent and insufficient, green capacity is building rapidly in bond, equity and emissions trading. A third finding concerns direct exposures of European financial institutions to CO2-intensive sectors, drawing on currently available supervisory reporting of large exposures of banks. Direct exposures appear to be limited and falling moderately on average, but with tail risk in the form of concentrated exposures in a few sectors and firms. A fourth finding stems from forward-looking exploratory scenario analysis that builds on the methodology developed by the DNB and in the ECB’s BEAST model. The analysis of the transition risk scenarios suggests that the costs to the economic or banking sector of even a sharp rise in carbon pricing or marked industrial shifts over a five-year timeframe are likely to be contained, and lower than for the potential losses due to physical risks resulting from climate change. Taken together, all four of these elements, beyond the initial quantification of climate risk for the euro area financial sector, also clarify data gaps and deepen knowledge about the relevant transmission channels that warrant further attention for modelling purposes.

While this report contains many new findings, it also raises more refined questions that can help to steer further work on addressing gaps in knowledge, notably data gaps and methodological investments. Both are needed to provide a solid foundation for potential evidence-based policy reflections. With regard to data gaps, both financial and non-financial reporting remain incomplete. Financial sector exposures and vulnerabilities to climate change currently involve an eclectic collection of existing supervisory data, market data sources and other data available to ATC/FSC members. Once more comprehensive granular data are available, the opportunities created as a result, for example from credit registers, should be explored. Climate risk measurement could also be improved. Additional data collections may be needed to supplement existing firm disclosures, which are patchy and at times heterogeneous. With regard to methodological investments, more climate-specific modelling (including long-term stress testing for banks and insurers) is needed. This would involve devising models with a larger scope (stronger inclusion of physical risk) and longer horizons (beyond the five-year horizon considered in this report). Moreover, the baseline long-term projection would need to be more clearly linked to meeting EU environmental goals in an orderly manner. Ultimately, analysis of systemic risks from climate change should provide the foundations for evidence-based macroprudential policy reflections. As a minimum, further work is needed to better frame disclosure needs to help address informational market failures associated with climate change risk, thereby providing a basis for effectively addressing the allocative market failures associated with climate change.

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