The Wide Angle

OCTOBER 2021  ISSUE NO. 7 |  Debt Business Magazine

By: Sam Theodore

Scope Insights​, UK

The ECB’s recently published economy-wide climate stress test represents in my view one of the most comprehensive efforts to-date for this type of exercise.

First, it is based on a vast amount of data from four million non-financial corporates (NFCs) worldwide and 1,600 banks in the euro area (EA).

 

Second, it drills down to an extremely high degree of granularity, looking in detail at each bank’s loan and investment exposure to climate-change risks and identifying both transition and physical risks.

 

Third, it is a step ahead of other stress tests recently undertaken in the Netherlands, UK, France and by the EBA in aiming to link transition and physical risks, the two main components of climate risk and two sides of the same coin, rather than assessing them separately.

 

Fourth, it attempts to provide pointed conclusions, beyond the need for NFCs and banks to strengthen climate risk management. On one hand, these conclusions are aimed at climate risk in general – looking at concentrations that are both geographic (for physical risk) and by economic sector (for transition risk).

 

On the other, they specifically address the challenge for EA banks: in essence, climate risk for banks stems from the mix and weight of counterparties in their loan and investment portfolios. The comprehensiveness and high informative value of the ECB’s climate stress-test report and its analytical clarity are commendable. But I also believe some aspects are questionable when it comes to the banking sector. The climate stress test was undertaken by the ECB, not its banking supervision area, though the results will inform the forthcoming supervisory climate stress test of individual banks that ECB Banking Supervision will carry out next year. Below I summarise the stress test’s main findings and elaborate on five caveats related to them:

  1. The 30-year timeframe (until 2050)
  2. Static balance sheets and the desired transition to dynamic balance sheets
  3. Uncertainties related to future technology advances and regulatory changes
  4. The interaction between transition and physical risks
  5. A key rationale for banks to focus on a key challenge which is less covered in the climate stress-test report.

 

ECB stress tests: key climate-risk takeaways

 

If left unchecked, the report warns that the frequency and severity of future climate events will cause devastation and significant disruption. But the changes necessary to address the climate challenge may themselves disrupt the economy and financial system. Even so, the ECB analysis shows that there are clear benefits in acting early for green transition. The short-term costs of the transition pale in comparison to costs of unchecked climate change in the longer term.

 

This is very much true with respect to banks. The ECB uses three transition scenarios: orderly (early transition), disorderly (delayed implementation of transition), and the hot-house scenario (no transition). It estimates that under the hot-house scenario, the aggregate probability of default (PD) of EA banks by 2030 will be 1.5% lower than under the orderly transition scenario. But over a 30-year horizon (by 2050), the PD under the hot-house scenario will rise by 7%.

 

In the absence of early green transition, physical risk (severe climate events) will become more dangerous and disruptive, with the tail risk in the countries and regions most vulnerable to harmful climate events. The ECB points out that countries in southern Europe are more vulnerable, due to the frequency of wildfires. Wildfires (associated with heatwaves) are flagged as the main type of physical risk in Europe, more so than flooding or rises in sea levels.

 

The ECB sees large NFCs as the biggest polluters – mostly due to the large amount of Scope 3 emissions (ca. 70% of total emissions – both upstream and downstream). On balance, they represent half of banks’ aggregate exposure to business counterparties but 90% of the pollution. And because it is mainly large banks that have material exposures to large NFCs, large banks will carry the lion’s share of losses in the event of unchecked physical risk.

The stress-test report notes that systemically important banks carry 80% of total climate-risk exposure for the 1,600-bank universe. The largebank climate-risk bias is especially present in systems with a large degree of banking concentration, such as France and Belgium. Physical risk (mostly wildfires) is present in 22% of aggregate bank exposures.

 

While specifically identifying physical risk as the main danger for banks’ expected loss (EL) in the longer term (by 2050), the ECB also cautions on the risk of green transition not undertaken early (by 2030). A disorderly or a hot-house scenario may lead to material and growing exposure to disruption triggered by regulatory changes or technology breakthroughs. This is especially true for resource-intensive sectors like mining, electricity/gas, water supply/waste, or segments of agriculture. And indirectly for the banks with material exposures to these sectors.

 

The stress-test report mentions the example of a high-emitting sector like coal mining: its green reconversion would translate into a significant increase in leverage – from 27% to 70%-90% – which would lead to a 100%-150% increase in PD for the lending banks.

 

This suggests that the greening of polluting industries, which bank lending is supposed to accompany and support, will by no means be a walk in the park for the next decade or so. But, clearly, the option of non-action is much worse for the longer term.

 

Based on the stress test’s conclusions, rather than repeating comprehensive all-encompassing exercises, one quicker but effective climate-risk assessment exercise could be to focus just on systemically important banks’ exposures to large polluting NFCs and sectors -- as the bulk of carbon and methane emissions come from them.

Five caveats

 

The ECB’s economy-wide climate stress test offers a solid framework, amply supplied with relevant data for future similar exercises related to climate risk – a field which will only increase in importance as time goes by. But when the rubber meets the road and the exercise turns toward steering banks to manage their loan and investment portfolios’ climate risks, some of the assumptions and conclusions may be questionable. Here are five caveats.

 

1. Using 30-year projections for banks’ expected losses

 

The 2015 Paris Agreement and the numerous studies and projects following it have been presenting climate-risk projections through 2050 and until the end of the century, centered on remaining within the 1.5 to 2 degrees temperature-rise caps. But transferring such projections to a bank’s own loss estimates over several decades can be risky.

 

As far as I am aware, this is the first instance that banks have been faced with the need for 30-year planning. Added to the inherent relativity of climate-change estimates over decades, this timeframe is well beyond the long-term strategic planning appetite and capabilities of most banks, especially when faced with the existential uncertainties of the fast-advancing digital age. Thinking over several decades is not how banks and markets are wired.

 

It is primarily the younger generation that feels that reversing climate deterioration is an existential priority and which can more directly relate to a deadline 30 years in the future. Most decision makers in banks – top management teams and board directors – belong to a different generation, and they are also rooted in a more traditional banker background.

 

When addressing a long-term challenge, the reaction will naturally be to focus on the shorter term. If this is the case, perhaps future climate stresstest exercises for banks should aim at setting the direction of travel for the very long term but with specific goals geared towards the shorter term, to match the mindset of top managers and directors.


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