On 18 March 2021, the European Central Bank (ECB) published a blog post by its Vice-President, Luis de Guindos. The blog post, Shining a light on climate risks: the ECB’s economy-wide climate stress test, describes the framework for the economy-wide climate stress test that the ECB is currently conducting.

The stress test is the first of its kind and encompasses almost all monetary financial institutions in the euro area and covers a period of 30 years into the future. Its aim is to assess the exposure of euro area banks to future climate risks by analysing the resilience of their counterparties under various climate scenarios.

The blog post mentions that the preliminary results from the stress test show that in the absence of further climate policies, the costs to companies arising from extreme weather events rise substantially, and greatly increase their probability of default. The resulting ‘hot house world’ will be particularly challenging for certain regions projected to become markedly more vulnerable to events such as heatwaves and wildfires in the future. Climate change therefore represents a major source of systemic risk, particularly for banks with portfolios concentrated in certain economic sectors and, even more importantly, in specific geographical areas. The results show that there are clear benefits in acting early. The short-term costs of the transition pale in comparison to the costs of unfettered climate change in the medium to long term.

The ECB plans to take a number of further steps to broaden and strengthen the preliminary results. First of all, the firm-level impacts will be used to assess banks’ resilience to climate risks through loans, security and equity holdings. The full set of results will be available by mid-2021, including how changes in firms’ solvency translate into changes in bank-level vulnerability to transition and physical risk.