On 23 January 2024, the European Central Bank (ECB) published a report focusing on the transition risks stemming from banks’ credit portfolios.
Key takeaways from the report include:
- Risks in relation to the transition towards a decarbonised economy can have a significant effect on the credit portfolio of a financial institution. These transition risks are drivers of credit, market, operational and liquidity risk. It is thus vital for financial institutions to assess the risks arising from the transition towards a decarbonised economy.
- If the transition towards a decarbonised economy becomes disorderly, there will be a growing need to quantify the transition risks in banks’ credit portfolios. Accordingly, alignment assessment is widely recognised as a useful method for quantifying transition risks in a credit portfolio. Although other methods give an indication of the carbon intensity of a credit portfolio at a certain point in time, alignment assessment provides insight into whether the corporations in a credit portfolio are moving towards low-carbon production.
- Based on forward looking production data for assets within the sectors most impacted by the shift towards a low-carbon economy, the report assesses the risk stemming from the (mis)alignment of banks’ financing with EU policy objectives. An alignment assessment is conducted using the open-source Paris Agreement Capital Transition Assessment (PACTA) methodology to determine bank-wide alignment rates. To assess and benchmark alignment at bank level, the technology-level (mis)alignments from PACTA are aggregated to present a net alignment rate for a given bank. In the future however, the PACTA approach to alignment assessment could be further developed to cover a broader array of sectors, such as shipping and aviation, as well as other types of risk, for example market risk.
- The euro area banking sector shows substantial misalignment and may therefore be subject to increased transition risks. Furthermore, around 70% of banks are also subject to elevated reputational and litigation risk.
- Banks can apply the approach used in the report to further develop their alignment assessment capabilities to help determine the transition risks they face as well as meet the impending disclosure requirements under the European Banking Authority’s Implementing Technical Standards on Pillar 3.
Frank Elderson (Member of the Executive Bord of the ECB and Vice Chair of the Supervisory Board of the ECB) has also written a blog on the ECB’s Supervision Blog titled “Failing to Plan is Planning to Fail”. He argues that misalignment with the EU climate transition pathway can lead to material financial, legal and reputational risks for banks. It is therefore crucial for banks to identify, measure and most importantly, manage transition risks, just as they do for any other material risk.