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The ECB’s climate risk stress test: essentially a learning exercise

15 July 2022
Banking supervision
“For what we have to learn to do, we learn by doing.” In its capacity as the EU banking supervisor, the European Central Bank (ECB) was keen to put Aristotle’s wise words into practice when conducting its climate risk stress test earlier this year. While it proved to be a good learning exercise for both banks and supervisory authorities alike, it is too early to call it a real test. A substantial amount of data is still missing, and the methodologies, models and scenarios need to be further developed.

The stress test as a climate risk assessment tool

It is indisputable that climate risks pose a major challenge for the economy and financial stability. Nonetheless, no one knows exactly when or to what extent we will be confronted with these risks. The measures we take today to combat climate change play an important role in this regard. If we wait too long and don’t take meaningful actions, we will be unable to avoid the consequences of climate change. We will experience heavier rainfall and flooding, more and longer droughts, and more frequent storms. These risks are referred to as “physical risks”.

In addition, there is another category of risks, called “transition risks”. These risks are related to the transition to a more sustainable economy. Structural changes in the economy, for example following a change in climate policy, may indeed lead to losses for the financial sector. Stricter COstandards could jeopardise the viability of the business model in certain sectors or companies. The longer we wait to take measures to build a sustainable economy, the more stringent the measures will have to be to achieve the desired objectives and the higher the resulting transition risks.

Many different scenarios are thus possible, which makes it extremely difficult to assess the risks involved. In this respect, stress tests and scenario analyses are very useful tools for financial institutions. A stress test is a specific type of scenario analysis; it is a forward-looking exercise in which the financial impact of a severe and unfavourable - yet credible - scenario is calculated.

Stress tests and scenario analyses are useful tools for financial institutions to assess the possible consequences of various scenarios.

Banks need to step up their efforts

The ECB expects the banks it supervises to carry out their own stress tests and scenario analyses to assess climate risks. The ECB’s recent climate risk stress test was conducted in three stages. The ECB first assessed where banks stood in terms of conducting climate risk stress tests and scenario analyses. It found that a majority need to step up their efforts: 59% have yet to integrate climate risks into their stress test programmes.

Source: ECB —

In the second stage of the exercise, banks were asked to calculate indicators to determine the percentage their assets and revenue originating from counterparties that are big emitters of greenhouse gases. This information allows the ECB to assess the transition risks to which banks are exposed, given that such counterparties are likely to be more affected by additional measures taken to mitigate the effects of climate change. In the third and final stage, the ECB provided banks with scenarios for the stress test exercise itself, involving the assessment of both physical and transition risks.

A grain of salt

The resulting risk assessments should however be taken with a grain of salt. The climate scenarios provided were indeed not very unfavourable. For example, the “heat and drought” scenario focused solely on the effects of these phenomena on productivity. Other consequences of heat and drought, such as possible migration flows and rising food prices or even food shortages due to crop failures, were not taken into account. Moreover, the scenarios did not factor in the slowdown in economic growth associated with the adverse effects of climate change, despite the fact that the models currently used by banks are perfectly suitable for calculating losses in a recession.

Moreover, the models used by banks have not been sufficiently adapted to take climate risk factors into account. As a considerable quantity of data was not yet available, only a third of the banks’ total assets were taken into consideration for purposes of the exercise, not to mention the fact that banks had to rely heavily on estimates and approximations.

For what we have to learn to do, we learn by doing.
In its capacity as the European banking supervisor, the European Central Bank (ECB) was keen to put Aristotle’s wise words into practice when conducting its climate risk stress test earlier this year.

A learning exercise

The abovementioned shortcomings lead us to believe that the real risks are still considerably underestimated. It is thus too earlier to consider this exercise a true test. Unlike with a traditional stress test, the results cannot be used to determine if banks have sufficient capital to withstand certain crises. Supervisors may nonetheless take into consideration certain aspects of the “test” when determining the risk profile of banks in the framework of their annual audit.  For instance, one of the questions that needs to be asked when assessing the strategy, administration and risk management of supervised institutions is whether they sufficiently consider climate risks and conduct stress tests for this purpose.  

In any case, the exercise turned out to be a very good learning experience for banks and supervisory authorities alike. Both were able to draw important lessons about, for instance, the scenarios, the approximation and estimation of unavailable data, the adaptation of models, etc.  

The ECB has already published some general guidance for banks and will issue more targeted guidance at a later stage to address specific challenges. For example, it will indicate the methods banks should use to estimate missing data. Moreover, both financial institutions and other firms will soon be required to release data on their vulnerability to physical and transition risks. It will thus be easier for banks to obtain information that will allow them to assess the risks to which they are exposed, as the latter are linked to the vulnerabilities of their counterparties.

The obligation for companies to release information on their climate risk vulnerability will help to create an important source of data for banks.

No climate risk stress test for “less significant” institutions at this stage

It should be noted that this exercise concerns only larger - so-called “significant” - institutions that are directly supervised by the ECB. No stress test is currently foreseen for “less significant” Belgian institutions, supervised by the NBB. However, the NBB recently sent these banks a questionnaire that allows them to self-assess if they meet climate and environmental risk expectations. The expectations for less significant institutions take into account the nature, scale and complexity of their activities. These banks are also expected to perform the necessary scenario analyses and stress tests to assess climate-related risks. Smaller banks will thus also be able to use the ECB’s stress test as a learning exercise and draw lessons from it.

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