Bank exposures to climate risks
The 2022 stress test was more of a learning exercise to determine whether European banks could assess their vulnerabilities to climate change rather than to offer concrete conclusions on the actual climate risks that the banks are exposed to, which would be taken into consideration by the ECB when setting additional capital requirements. Drawing such hard conclusions would have been difficult to begin with, considering the data challenges the banks are still facing when it comes to measuring climate risks. As discussed above, most banks still heavily rely on proxies to measure, for instance, the Scope 1, 2 and 3 emissions of their counterparties, with diverse outcomes. This illustrates not only the importance of further customer engagement, according to the ECB, but also the applicable boundaries when it comes to interpreting the results of the stress test.
That said, the ECB was able to draw some insightful conclusions, including from its analysis on the sensitivity of the European banking sector’s income to transition risks, and its exposure to carbon-intensive sectors under module 2:
- The banks participating in the stress test, by the end of 2021, generated more than 60% of their interest income from business with non-financial corporates belonging to the top 22 most carbon-intensive sectors. These 22 industries represent just 54% of the overall EU economy. Among these greenhouse gas-emitting sectors, the largest share of income was, however, attributable to sectors with relatively lower intensity, such as real estate activities. Global systemically-important banks were among the group of banks less reliant on income from these sectors, while small domestic retail lenders were among the most reliant.
- However, to assess banks’ exposure to carbon-intensive sectors, the exposure-weighted average of the GHG emission intensity, based on Scope 1, 2 and 3 emissions was computed. The seven highest GHG emitting sectors are: 1. mining and quarrying, 2. manufacturers of coke and refined petroleum products, 3. manufacturers of non-metallic products, 4. electricity, gas, steam and air conditioning supply, 5. water transportation, 6. manufacturers of chemical products, and 7. metal products. These sectors represent 28.8% of the 22 sectors considered, but account for more than 50% of the carbon intensity of the corporate portfolios of banks. G-SIBs and universal banks then hold the largest share in the seven most carbon-intensive industries, and thus have the highest corporate portfolio carbon intensity.
Furthermore, in relation to the bottom-up stress test under module 3, the short-term disorderly scenario projects banks reported and indicative losses at €53bn, and €17bn losses under the short-term physical scenarios (drought & heat risk and flood risk). The ECB believes the reported €70bn in aggregate losses may significantly understate the actual transition risk, as the climate shock scenarios were not accompanied by an overall economic downturn, while the included exposures only account for one-third of the total. Besides, the climate risk modelling capacity of banks is still at a preliminary stage. What is clear though, is that banks do stand to benefit from an orderly green transition, as this will lead to lower loan losses for banks than a disorderly or inactive transition.
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