Climate Shocks Can Threaten Financial Stability, Says ECB and ESRB Report
In the event of a disorderly green transition, climate risk shocks might spread throughout the financial system. Financial market losses caused by the abrupt repricing of climate risks might impact investment funds and insurers, as well as cause business defaults and bank credit losses. Together, macroprudential and microprudential policies should mitigate systemic risk.
The European Central Bank (ECB) and the European Systemic Risk Board (ESRB) released a joint assessment of the potential impact of climate shocks on the European financial system.
The findings indicate that climate hazards can rapidly spread and hurt businesses and banks. The report presents additional information regarding the systemic nature of climate risks and lays the groundwork for a macroprudential response.
The report highlights multiple amplifying factors for climate-related financial system risk. Due to the economic and financial ties between and among banks and businesses, transitional risks may be exacerbated.
For instance, a rise in carbon prices could increase the possibility that the default of one company leads to the default of another. This is particularly applicable to carbon-intensive businesses, but it might also damage their less carbon-intensive competitors.
Moreover, interconnected natural hazards, such as water stress, heat stress, and wildfires, can raise physical climate risk because they can cluster and worsen one another.
Additionally, market dynamics can increase the monetary impact of physical dangers. A climate shock, for instance, might prompt a sudden reassessment of climate risk pricing, resulting in fire sales in which financial institutions—particularly those with overlapping portfolios—sell a significant number of exposed assets at distressed prices simultaneously.
A scenario study reveals that climate threats to the financial system may manifest in a particular sequence. Initially, unanticipated climate shocks could have a sudden influence on market prices, affecting the portfolios of investment institutions, pension funds, and insurance firms.
Second, this quick repricing could result in the default of enterprises, leading to losses for susceptible banks. In a disorderly transition scenario characterised by a rapid and considerable increase in carbon costs, insurers and investment funds may incur market losses of 3 per cent and 25 per cent on stress-tested assets in the near term.
A transition to net zero by 2050 could mitigate the effects of such shocks on companies and banks, decreasing the likelihood of corporate defaults by 13 to 20 per cent in 2050 compared to current policy. It would also reduce bank credit losses.
The research evaluates the applicability of macroprudential measures as part of a broader policy response to climate change's financial effects. It strengthens the argument for modifying current instruments, including systemic risk buffers and concentration thresholds. Such measures might supplement microprudential efforts, such as the ECB's supervisory climate agenda, which includes the ongoing thematic evaluation of climate risks and the 2022 climate risk stress test.
The report draws upon two earlier ECB/ESRB climate risk reports. It is a component of the ECB's climate agenda, which outlines all of its ongoing climate-related activity, including attempts to improve the assessment of climate risks. This study consists of an update to the 2021 economy-wide climate stress test and the continual monitoring of climate risk in the financial sector.
Source: European Central Bank
