Orderly green transition would lead to lower loan losses for banks

On Friday 8 July, the ECB published its climate stress test results as part of its climate roadmap. The 2022 climate stress test was primarily conducted as a learning exercise, aiming to enhance the ability of both the European banking sector and the central bank to assess climate risks. As such, the stress test results will not have any direct capital implications, even though the ECB indicates that it will consider these supervisory findings in a qualitative and indirect way in the annual SREP assessment.

While the number of banks with a climate stress testing framework has increased, the exercise still does not capture a wider range of climate change risks across complete balance sheets, instead concentrating on a smaller part of the books. The main bottleneck is access to good quality data.To obtain better quality data, banks should invest in data collection, and rely more on actual data instead of proxies.

When it comes to concrete findings of distinct banking sector exposure to the green transition and physical climate risks, the latest stress test results were probably somewhat less insightful than the economy-wide stress test results published by the ECB in September 2021. What remains clear though, is that banks do stand to benefit from an orderly green transition, which will lead to lower loan losses for banks than a disorderly or inactive transition. The 2022 climate risk stress test confirms that carbon-intensive sectors, such as manufacturers of refined petroleum products, mining and minerals are indeed most exposed to transition risks. The mining, agriculture and construction sectors also appear most exposed to physical climate risks arising from heat and drought, particularly in geographical areas that are more vulnerable to extreme temperatures.

While many banks are planning to finance the green transition, the targets are not yet concrete. More banks indicate that they could reduce their lending to the most polluting sectors than to other sectors, which we believe could be driven by regulatory or perhaps climate change-related reputational considerations.

Share of banks currently including climate risk in their stress test frameworks

Usage of climate risk stress testing is increasing, but slowly

An important part of the whole climate risk stress testing exercise was for the ECB to better understand banks’ progress on integrating climate risks into their internal stress-testing frameworks. To form an overview of banks’ climate risk stress-testing capabilities, the ECB asked banks for detailed information on their climate stress testing framework, governance and modelling practices. This allowed the ECB to use a scoring system to compare banks to each other in terms of their preparedness.

Some 41% of banks reported that they had a climate risk stress-testing framework in place as of end-2021. Although still relatively limited, this is higher than what has been published previously. For example, based on the ECB’s report on the state of climate risk management in the banking sector that was published in November 2021, 25% of banks had performed a climate risk-related stress test and 13% had integrated climate risks into their regular stress-testing frameworks. So some improvement can be seen.

However, banks do not, at least yet, utilise their climate stress-testing capabilities to a larger degree in their business decisions. Only 19% of banks with a climate stress-testing framework in place, actually used it to inform their loan granting process. Furthermore, around 40% of banks with a framework did not consider the test outcomes in their business strategy. Also, the testing was not extended to the whole balance sheet. Meanwhile, 37% included only one or two climate risk transmission channels such as credit or counterparty risks or market risks. And 35% captured only 1-3 portfolios such as corporate loans, household loans or SME loans. Climate stress testing involved mainly physical risks (71%) and transition risks (81%). Liability or reputational risks were less frequently captured (24%).

While the climate risk stress-testing frameworks mostly had a validation process in place (93%), 75% of them had the same business process responsible both for the development and validation of the framework. Around 60% of those with a framework did not disclose any results in their Pillar 3 reporting.

Three-quarters of banks with a framework did include climate-related and environmental events in their operational risk stress testing or scenario analysis. For assessing reputational risks, less than 40% of banks indicated that they included climate-related and environmental events.

The number of banks with a climate risk stress testing framework in place is likely to increase only gradually in the coming years. Only 35-39% of banks, that did not yet have a framework in place, expect to be able to implement transition or physical risks in their frameworks within a year. Over 50% of banks need at least one to three years to incorporate physical and or transition risks into their stress-testing framework. Almost all mention the need for data to enhance their climate risk stress testing framework.