Systemic climate risks spotlighted by ECB

Climate shocks could quickly ripple through the euro zone economy as financial interlinkages amplified dangers and losses, according to a study by the European Central Bank and the European Systemic Risk Board.

  • Risk shocks could spread throughout the financial system, notably in the event of a disorderly green transition
  • Financial market losses from abruptly repricing climate risks could affect investment funds and insurers as well as trigger corporate defaults and credit losses for banks
  • Macroprudential and microprudential policies should work in tandem to mitigate systemic risk

The report identifies several amplifiers of climate risk across the financial system. Transition risks may be magnified because of economic and financial linkages between and across banks and companies. For example, a surge in carbon prices could increase the likelihood that the default of one company leads to the default of another. While this particularly applies to high-carbon companies, it could also affect their less carbon-intensive counterparties.

Meanwhile, interdependent natural hazards – such as water stress, heat stress and wildfires – can amplify physical climate risk, as they can cluster together and exacerbate each other. Market dynamics can also magnify the financial impact of physical risks. For example, a climate shock could lead to a sudden reassessment of climate risk pricing, thereby causing fire sales, where financial institutions – especially those with overlapping portfolios – quickly sell a large number of exposed assets at the same time at distressed prices.

“In a disorderly transition scenario, marked by an immediate and substantial increase in carbon prices, respective market losses of insurers and investment funds could potentially amount to 3% and 25% (of) stress-tested assets in the near term,” the report said.

These market dynamics could then amplify each other, because a climate risk could quickly reduce the value of assets and lead to fire sales. Financial institutions would dispose of a large number of exposed assets at distressed prices, leading to a downward spiral in valuations.

The ECB, which supervises the biggest banks in the 19-country euro zone, has for years argued that climate change is a top risk and has pushed lenders to acknowledge and reduce their exposures, but with little success so far.

“No meaningful reduction in emission intensity in the loan portfolios of euro area banks has taken place in recent years,” the report said. Among banks, “exposures to climate-related losses also remain concentrated …, with more than 20% of potential losses residing in the holdings of 5% of euro area banks.”

Beyond the corporate sector, households also appeared to be vulnerable, with almost half of outstanding home loans having been to made to borrowers who have high ratios of energy costs to income, the report added.

An orderly green transition, however, would reduce corporate defaults by up to a fifth in 2050, the report estimates.

While there are no regulatory instruments in place for such risks, systemic risk buffers or concentration thresholds to reduce exposure to carbon-intensive sectors could reduce dangers, the report adds.