Luis de Guindos, Vice-President of the European Central Bank (ECB), recently published a blog post describing the framework for the economy-wide climate stress test that the Bank is currently conducting and summarizing its preliminary results (final version to be completed by mid 2021).
The test encompasses approximately four million companies worldwide and 2,000 Eurozone banks, covering a timeframe of 30 years into the future, and providing a more balanced picture of the long-run trade-offs involved in climate policies. The most comprehensive and innovative exercise of its kind to date aims to assess the exposure of euro area banks to future climate risks by analyzing the resilience of their counterparties under various climate scenarios.
ECB defined three main scenarios for its analysis: 1) Orderly transition with limited physical risks; 2) Disorderly transition with limited physical risks; 3) Hot house world with extreme physical risks. The ECB scenarios are based on those provided by the Network for Greening the Financial System but have been adjusted to capture the different categories of risks and its relationships.
Climate-related risks to the economy and financial sector are usually divided into two categories: physical risks and transition risks. The relationship between both categories is one of the key elements captured and quantified in the ECB economy-wide climate stress test. Physical risks differ across countries and regions, with southern Europe on average more susceptible to heat stress and wildfires, while middle and northern Europe are more vulnerable to flooding risk. Regarding transition risks, in case of a disorderly transition, the increase in probability of default is more significant for the most polluting sectors, such as mining, electricity and transport.
Preliminary results 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. A timely and effective transition to a greener economy is always the preferable course of climate policy action. Climate change thus represents a major source of systemic risk, particularly for banks with portfolios concentrated in certain economic sectors and geographical areas.