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Climate shocks can spread quickly through financial system: ECB

© Shutterstock / worawit_jCoins being balanced on Jenga game blocks.

European Central Bank (ECB) warns climate change is not just bad for health and environment, it’s also bad for the economy and a risk to financial stability. The research shows the banking system is no more prepared for climate change than business.

An analysis published by the European Central Bank (ECB) and the European Systemic Risk Board (ESRB) highlights how climate risk shocks can spread through and destabilise financial systems in Europe. This is what Verisk Maplecroft recently called cascading risk.

The published report fills an analytical gap on the systemic risks of climate change. To effectively manage price stability and inflation means that central banks must have an informed foundation for the development of macroprudential policy to mitigate risks to the financial system as the world begins to feel the impact of climate change.

Despite increasing central bank, investor and media focus on climate risk, the analysis found there has been no meaningful reduction in emission intensity in the loan portfolios of euro area banks in recent years. That means the market is still failing to respond to signals on climate risk.

Exposures to climate-related risks remain concentrated, with more than 20% of potential losses residing in the holdings of 5% of euro area banks. Certain sectors remain particularly exposed, with mining, manufacturing and electricity sectors representing around 60% of transition risk exposures in euro area banks portfolios.

The concentration of climate risk in euro area banks means that there is no buffer to potential climate shocks, and increases the vulnerability of the financial system as a whole.

ECB climate change report shows domino effect on financial stability

Building on an analysis carried out by ECB and ESRB in 2021, the report identifies several amplifiers of climate risk across the financial system, such as transition risks and physical risks.

Transition risks refer to the economic implications of the shift towards net zero and more sustainable business and finance practices. These transition risks stem both from consumer demand for greener products, technology innovations, as well as government-led climate policy. These risks are magnified due to “economic and financial linkages between and across banks and companies”.

For example, if a government establishes a carbon prices and this price suddenly surges, it could put an immense financial burden on carbon intensive industries. This could lead to the company defaulting, and increases the likelihood of other related companies to default as well.

Physical risks include the natural hazards caused by climate change such as water stress, heat stress and wildfires, especially as they “cluster together and exacerbate each other”. These natural disasters can put a company or financial firm’s assets at risk, forcing the rapid sale of these exposed assets and impacting market prices.

For example, analysis by a panel for the US Commodities Futures Trading Commission (CFTC) found that wildfires in California, which are now becoming an annual event, found that the fires could spark a financial crisis in the US by setting in motion a variety of defaults and market disruptions, including a ‘fire-sale of financial securities’.

The wildfires have lowered home values as 3 million of the state’s 12 million homes are at high risk from wildfires. Insurance rates have skyrocketed, further depressing home prices and increasing the risk of mortgage default. A drop in real estate value can impact tax revenue from government, increase debt, and potentially lead to bond defaults.

The joint ECB and ESRB report notes that the interconnectedness of these amplifiers could have a devastating domino effect that could “aggravate” these specific risks.

For example, an unforeseen natural disaster could impact market prices of a certain asset, impacting investment portfolios, pensions funds, and insurance companies. This could in turn lead to companies defaulting and create losses for the exposed banks.

ECB: climate change impacts are inevitable, financial instability is not

The report warns the impacts of climate change are inevitable, and it is crucial for financial regulators and central banks to adapt to the realities of a warming world instead of turning a blind eye.

Analysis in the report finds that in a “disorderly transition scenario marked by an immediate and substantial increase in carbon prices”, market losses for insurers and investment funds could add up to 3% and 25% on stress-tested assets in the near term.

Whereas an “orderly transition” to net zero emissions by 2050 could “soften such shocks and alleviate the fallout for companies and banks”, slashing the probability of corporate defaults by around 13-20% in 2050 compared to current policies.

ECB and ESRB call for a “coordinated European macroprudential response” to adapt financial systems to climate risks in order to avoid a potential crisis. Currently, there are no macroprudential instruments that are “readily available and fit for purpose without some adaptation”.

Instruments to limit concentration of risk could help “address systemic risks across the board” according to the report. Improving the quantity and quality of climate disclosures to create more transparency can also help manage risk, although the report warns that this may also inhibit efficient market pricing.

Financial risks go beyond borders

The report also calls for strong international coordination as there are “clear spillovers and interdependencies between global jurisdictions”. The 2008 financial crisis and the current economic implications of the Ukraine crisis have both shown how an issue in one part of the world can quickly spread across to affect economies in other parts of the world.

Central banks in other countries are therefore also waking up to the need of macroprudential policies to manage climate risks for the health of their financial systems.

Elisabeth Stheeman, a member of the Bank of England’s Financial Policy Committee as well as the Audit and Risk Committee of the Asian Infrastructure Bank has stressed the importance of macroprudential policy to tackle financial stability risks of climate change.

“Firms cannot diversify away from their exposure to the planet. And in that sense, climate change could be described as the ultimate systemic risk”, warned Stheeman in a speech earlier this year.

Bank of England 10 point plan for financial climate resilience

The Bank of England has published a 10-point pledge to ensure financial resilience against climate risks. The pledge includes supporting an orderly economy-wide transition to net zero emissions, promoting adoption of global disclosure standards such as TCFD, and further analyse the extent of climate risks in England and internationally.

The CFTC has also published a report highlighting the systemic risk of climate change on financial systems, while acknowledging that regulators and market participants are still in the early stages of “understanding and experimenting with how to best monitor and manage climate risk”.

It is clear that central banks and regulators now see climate change as a systemic risk for financial systems. However it is also evident that they are still not sure how to address these risks, with most reports and pledges offer high-level rhetoric but little in terms of solutions. It will be crucial for central banks to get this right to not only help avoid a climate crisis, but also a financial crisis.

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