Environmental protesters take to the streets during a Fridays for Future demonstration in the financial district of Frankfurt, Germany, last August.
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The results of the European Central Bank’s first climate risk stress test show that most euro area banks do not sufficiently incorporate climate risk into their stress testing frameworks and internal models.
In a report published on Friday, the ECB said the findings supported the view that banks should increase their focus on climate risk.
It comes at a time of intense heat and scant rainfall in southern Europe, rising energy prices and the prospect of gas supplies to the region being cut by Russia in response to sanctions imposed over the Kremlin’s crackdown on Ukraine.
Certainly, the world’s leading climate scientists have warned that humanity has reached “now or never” territory to avert the worst of what the climate crisis has in store.
“Eurozone banks urgently need to increase their efforts to measure and manage climate risk by filling current data gaps and adopting good practices already present in the sector,” Andrea Enria, president of the ECB’s Supervisory Board, said in a statement.
A total of 104 banks participated in the test, which is the first of its kind, the ECB said, providing information in three modules or categories. These include their own climate stress testing capabilities; their dependence on carbon-emitting sectors; and their performance under different scenarios over several time horizons.
The results of the first module found that approximately 60% of banks still do not have a stress testing framework for climate risk.
Similarly, the ECB said most banks do not include climate risk in their credit risk models and only 20% consider climate risk as a variable when lending.
As for banks’ reliance on carbon-emitting sectors, the ECB said that overall, almost two-thirds of banks’ income from non-financial corporate clients comes from greenhouse gas-intensive industries.
In many cases, the report found, banks’ “funded issues” come from a small number of large counterparties, increasing their exposure to issue-intensive sectors.
Within the third module, the results were limited to the 41 directly supervised banks to ensure proportionality to smaller banks. It requires lenders to forecast extreme weather losses under various transition scenarios.
The findings warned that credit and market losses could total around 70 billion euros ($70.6 billion) this year for 41 directly controlled banks.
However, the ECB noted that this “significantly underestimates the actual climate-related risk” as it reflects only a small part of the actual danger. This is partly due to the paucity of available data.
“This exercise is an important milestone on our way to making our financial system more resilient to climate risk,” said Frank Elderson, vice-chairman of the ECB’s Supervisory Board. “We expect banks to take decisive action and develop robust climate stress testing frameworks in the short to medium term.”
ECB President Christine Lagarde earlier said the central bank was taking steps to mainstream climate change “into our monetary policy operations”.
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The ECB said it collected both qualitative and quantitative information with a view to assessing the sector’s preparedness for climate risks and gathering best practices to address climate-related risks.
The report concludes that most banks will need to work further on improving the governance structure of their stress testing frameworks, data availability and modeling techniques.
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