On 21 November 2019, the European Central Bank (ECB) published a speech given by Luis de Guindos, Vice-President of the ECB, at the European Savings and Retail Banking Group Conference, “Creating sustainable financial structures by putting citizens first” focusing on the risks for the financial system in relation to climate change and its role in facilitating transition.

Mr de Guindos defines the two main risks for financial stability as physical risks that occur from increasingly frequent natural disasters and transition risks that arise from uncertainties surrounding the timing and speed of the transition to a low carbon economy. Mr de Guindos chooses to focus on the latter, particularly on financial institutions exposures to transition risks.

In his speech, Mr Guindos comments on how the information provided by banks and insurers on climate-related risks in scarce and inconsistent. The majority of financial institutions disclose the impact of their business travel, commuting and other energy usage but are reluctant to disclose most of their climate-related risk that stems from financial activities. Only 5 of the 26 largest banks and insurers disclose the impact of their financial assets and none provide full disclosure. Unless disclosures improve, market discipline is unlikely to incentivise financial institutions to address transition risk.

The ECB is currently developing an analytical framework for carrying out a climate risk stress test analysis for the euro area banking sector. Mr de Guindos describes that the pilot test framework will be macroprudential in nature, and will allow the ECB to analyse the system-wide materiality of transition risks for banks’ solvency, along with their lending capacity and the implications for the overall economy. The aim of the stress test will be to increase the industry’s knowledge of the financial impact of climate risks, environmental policy trade-offs and overall economic resilience as banks will need to treat risks from climate change with the same respect as other financial risks.

Mr de Guindos then turns his attention to how the financial sector can help smooth the transition to a low carbon economy through equity investment. Investors with a longer investment horizon and a greater appetite for projects that are both high risk and high potential return, may be better placed to finance environmentally sustainable innovation than credit investors. In Mr De Guindos view, this greatly expedites the need to develop the capital markets union to unlock the potential for deeper equity markets to help fund new green technologies to assist with the transition.