The European Central Bank (ECB) ran its first Climate Risk Stress Test during the first half of 2022, designed to discover European banks’ preparedness to withstand the economic impacts of climate change.
The test, which was described by the ECB as “an unprecedented learning exercise”, also aims to help the ECB identify any weak links in EU regulation and guide the development of best practice for the financial sector’s approach to managing climate-related risk. A key rationale for the exercise is to “enhance data availability and quality and allow supervisors to better understand the stress-testing frameworks banks use to gauge climate risk.”
The results of the ECB Climate Risk Stress Test, recently published, are set to have a considerable impact not just on financial institutions themselves, but also on customers seeking to secure credit and investment funding.
How are banks exposed to climate risk?
The financial sector is significantly exposed to climate risk on two key fronts. First, there are the physical risks resulting from rising greenhouse gas emissions. These include extreme weather events that can physically destroy assets and disrupt supply chains, as well as permanent long-term changes such as rising sea levels and altered weather patterns.
Second, there are the transition risks associated with the changes that governments, industries and consumers make in response to climate change. These include increased regulation, the transition to alternative fuel sources, and changes in public consumption of goods and services, among a wealth of other issues.
Both factors have the potential to affect the health of investments, the sustainability of returns and the stability of financial markets. Failure to accurately identify climate risk and establish management and mitigation strategies will result in significant financial and economic disruption. The ECB climate stress test is aimed at understanding how far banks are succeeding in gaining visibility of the climate risk associated with their business.
The structure of the ECB climate stress test
The climate stress test has three distinct modules. The first is an overarching qualitative questionnaire to assess how banks are building climate risk management capabilities and how mature their approach is.
The second module is a peer benchmark analysis comparing banks across a common set of climate risk metrics including how much banks rely on income from carbon-intensive industries and what volume of greenhouse gas emissions they finance. The ECB says module two “will provide an indicative proxy for the sustainability of banks’ business models and how exposed banks are to emission-intensive companies.” Clearly, responding to this module requires banks to have detailed visibility into the emissions performance of the companies they finance, meaning those organisations must – at a minimum - be able to deliver comprehensive GHG data.
The third module is a “bottom-up stress test” that examines banks’ preparedness for the transition and physical risks described earlier. It looks at the potential impact of extreme weather events if they took place in the next 12 months, the effect of a rapid change in carbon pricing if it took place over the next three years, and how banks would respond to different transition scenarios over the coming 30 years.
Banks were asked to consider three scenarios: An “orderly” transition – the best-case scenario where both physical and transition risks remain at the lowest level. A “disorderly” or “late action” scenario where transition costs are high. Finally, a “hot house world” scenario where climate change exerts high physical impacts.
The outcomes of the ECB climate stress test: data delta is a key concern
During the test preparation phase it became clear that banks do not currently hold all the data required by the ECB.
As a stop-gap measure, they had to rely on a mix of publicly available data, third-party data providers and proxies to supplement their own information. KPMG reported that, “as of February 2022, the proportion of actual Scope 1 and 2 GHG emissions data collected to date remained below 40% on average and the availability of actual EPC ratings was below 30% for half of banks.”
This problem was highlighted when the results of the climate stress test were published. The ECB concluded that “banks do not yet sufficiently incorporate climate risk into their stress testing frameworks.”
Chair of the ECB’s supervisory board, Andrea Enria, said: “Euro area banks must urgently step up efforts to measure and manage climate risk, closing the current data gaps and adopting good practices that are already present in the sector.”
The report found that “banks need to step up their customer engagement to obtain more accurate data and insights into their clients’ transition plans”, notably adding that, “This is a precondition for banks to gauge and manage their exposure to climate risks going forward.”
In monetary terms, the ECB estimated that banks currently face EUR70billion in losses under the hot-house world scenario, underlining the urgency to develop risk management strategies commensurate with the potential level of impact.
What do these outcomes mean for customers seeking finance?
All the banks participating in the test are expected to take action based on the feedback they have received and the ECB plans to publish a set of best practices in the last quarter of 2022.
On the basis of the test findings, it seems certain that commercial credit and investment funding will become harder to access for organisations that cannot provide robust and complete data on GHG emissions. As scrutiny intensifies, financial institutions will require increasingly detailed information on the maturity of companies’ ESG performance and their plans for decarbonisation in order to protect their business and reduce exposure to climate risk.
One of the mechanisms through which this is likely to play out is via reporting requirements such as the Financial Standards Board’s Task Force on Climate-related Disclosure (TCFD) initiative. This is specifically designed to provide a clear and consistent reporting framework that helps stakeholders such as banks and investors understand and compare carbon-related assets.
The TCFD is now mandatory for listed commercial companies, large private companies and financial sector institutions in the UK and is likely to extend to other organisations in the long run. Across Europe, the adoption of the Directive on Corporate Sustainability and Due Diligence Reporting will be implemented in phases from 2024. It will require all listed and unlisted companies with 250 or more staff and €40m turnover or more to disclose the impact of their activities and supply chains on the environment and people every year.
How to prepare for mandatory ESG disclosures
The shift towards mandatory ESG disclosures means organisations should act now in preparation. Meeting the requirements entails a whole-business approach involving cultural changes together with investment in people, processes and technology.
Areas to consider include ensuring strong leadership is in place; identifying relevant goals; understanding key frameworks; enabling robust data collection; utilising technology; and developing a strong reporting capability.
For more on how to prepare for mandatory ESG disclosures, read Diligent’s eBook “Six Foundational Components of a Mature ESG Programme”.
