On 8 July 2022, the European Central Bank (ECB) published the results of its 2022 climate risk stress test.
The results provide that, banks do not yet sufficiently incorporate climate risk into their stress testing frameworks and internal models, despite some progress being made since 2020.
Key findings from the stress test include:
- Around 60% of banks do not yet have a climate risk stress-testing framework. Similarly, most banks do not include climate risk in their credit risk models, and just 20% consider climate risk as a variable when granting loans. Banks currently fall short of best practices, according to which they should establish climate stress-testing capabilities that include several climate risk transmission channels (e.g. market and credit risks) and portfolios (e.g. corporate and mortgage).
- The second module of the test finds that, on aggregate, almost two-thirds of banks’ income from non-financial corporate customers stems from greenhouse gas-intensive industries. In many cases, banks’ “financed emissions” come from a small number of large counterparties, which increases their exposure to transition risks. Banks often rely on proxies to estimate their exposure to emission-intensive sectors. While this is a good first step to closing the data gaps, banks need to step up their customer engagement to obtain more accurate data and insights into their clients’ transition plans. This is a precondition for banks to gauge and manage their exposure to climate risks going forward.
- Findings show that banks’ vulnerability to a drought and heat scenario is highly dependent on sectoral activities and the geographical location of their exposures. The impact of this risk materialises through a decrease in sectoral productivity, e.g. in agriculture and construction activities, and an increase in loan losses in the affected areas. Similarly, in the flood risk scenario, real estate collateral and underlying mortgages and corporate loans are expected to suffer, particularly in the most affected locations.
- The results show that an orderly green transition translates into lower losses than disorderly or no policy action. However, banks barely differentiate between various long-term scenarios as they lack robust strategies, other than the tendency to reduce exposures from the most polluting sectors and to support lower-carbon-emitting businesses. Therefore, banks must consider direct and indirect transmission channels in their strategic long-term plans.
The climate stress test is part of a broader set of ECB activities to assess banks’ level of preparedness to properly manage climate risk. These results will feed into the Supervisory Review and Evaluation Process from a qualitative approach.
All participating banks have received individual feedback and are expected to take action accordingly, in line with the set of best practices that the ECB will publish in the final quarter of 2022.