The European Commission (EC) is asking the EU’s banking, insurance and securities regulators to conduct a stress test of the entire financial system. It is intended to check for vulnerabilities to climate-related risks and to assess the gaps in financing needed to achieve its ‘Fit for 55’ emissions reduction targets by 2030.
- The EC has recommended that the EU’s financial regulators conduct a one-off stress test to check the financial system’s readiness to meet the goals of the ‘Fit for 55’ legislation.
- As the deadline to meet the 2030 goals approaches, the EU seeks to anticipate and mitigate vulnerabilities in the financial system.
- The idea is to gauge how physical and transition climate risks impact the interrelated European financial system, and how it could support sustainable financing under duress.
According to the EC, an additional €350 billion in annual investment will be needed by the EU’s energy system to meet its 2030 emissions reduction targets. With the deadline fast approaching, the EC has acknowledged that public spending alone cannot help meet its targets, and wants to ensure that the mechanisms it has created to attract and direct private funds to finance the transition remain intact.
What is driving the need for the stress tests?
In a letter addressed to chairs of the European Insurance and Occupational Pensions Authority (EIOPA), the European Securities and Markets Authority (ESMA), and the European Banking Authority (EBA), John Berrigan, head of the EC’s financial services unit, outlined the EC’s need to assess the financial system’s resilience to climate risks and being able to meet the EU’s 2030 goals.
The purpose of any stress testing in a financial system is to check for vulnerabilities to adverse external impacts, and to anticipate the remedial action needed to restore balance to the markets. In relation to climate risk, the external shocks can be physical and related to the transition.
Progress towards financing sustainable activities needed to achieve the EU’s 2030 targets, particularly in attracting capital from the private sector, could suffer a severe setback if the financial system were not adequately prepared to face adverse climate shocks.
A major aspect of conducting stress tests is also to ensure that financial institutions are adequately funded, and have the requisite assets to deal with potential financial upheaval. In the event that private capital is withdrawn from the market, for example, the system must have adequate reserves to restore calm in the markets, and to continue to conduct business.
Berrigan said: “To ensure financial stability and to enable the financial sector to play its role in financing the transition, we need to be aware of any potential vulnerabilities in the financial sector and of how stress in the financial system could affect the transition to the 2030 goals.”
What entities are included and what is the timeline for the stress test?
In a bid to assess the impact of adverse climate-related risks on the entire European financial system, the one-off stress test will be carried out by banks, insurance companies and securities firms, in conjunction with the European Central Bank (ECB).
The EC wants to gauge the extent of contagion across the different sectors and secondary effects that might affect each sector, as well as to ensure consistency in the application of the criteria for the tests and in developing solutions.
In order to meet the timelines, the EC recommended that the team responsible for conducting the stress test develop a roadmap and schedule, apprising the supervisory authorities and the EC of its progress. Special attention should be paid to milestones relating to scenario validation, completion of tests by sector, and the incorporation of the data and findings into a final report.
With the 2030 timeline in mind, the EC recommended that the tests commence immediately, and could use year-end-2022 balance sheet data to build their models and scenarios. It hoped to get the results of the exercise by the end of 2024, and no later than the first quarter of 2025, so as to be able to provide the final report to the new EC, after the current term ends in October 2024.
What is the scope of the stress test?
In conducting the stress test, the EC instructed the different sectors to include extreme, albeit credible, scenarios that could impact the financial system by 2030. These could result from both the near-term impacts of physical climate change and the longer-term changes caused by a transition to a low-carbon economy.
For example, a climate-related disaster such as flooding or severe drought could cause catastrophic loss, requiring large reparations or bailouts of entire sectors. Similarly, stranded assets resulting from the transition away from fossil fuels could result in a correction to asset prices, and cause balance sheet damage and loan losses for banks.
A combination of physical and transition risks, alongside macroeconomic or systemic changes due to technology disruptions or regulation, could be another set of scenarios. To ensure consistency with other stress tests conducted across the financial system, the EC recommended that they are developed by the European Systemic Risk Board.
A comparison of the performance of the financial system under these adverse scenarios should also be made with the planned progression of the EU economy, using established economic forecasts, towards achieving the targets of the Fit for 55 legislation.
Reporting on the exercise will have to include details on the different impacts by sector, type of financial institution and country. The EC intends to go beyond looking at capital adequacy in the case of shocks to the system and look at the availability of capital to fund sustainable growth despite adverse climate and economic impacts.
For example, some EU countries turned to coal following the rise in gas prices from the war in Ukraine, justified by ensuring their energy security. In doing so, however, these countries risked jeopardising not only their nationally determined contributions to emissions reductions, but also risked the EU’s ‘Fit for 55’ targets.
By conducting the one-off stress tests related to climate risks, the EC is hoping to find out what it would cost to keep funding green activities and to avoid a similar regression in the progress towards climate goals..