Climate risk stress test is underestimated in Europe
Background
The results of the climate risk stress test performed by the European Central Bank this year show the preparedness and ability of the European banking sector to assess climate-related risk. As a joint learning exercise for regulators and banks it supports vital processes such as the Supervisory Review and Evaluation Process (SREP), as well as other regulatory initiatives such as the ECB thematic review and disclosure requirements for ESG risks under Pillar 3.
But what have we learned from it so far?
From the assessment of 104 systematically important (SI) institutions it became clear that many of them are at a very early stage in the development of robust stress testing capabilities for climate-related risks. Particularly, banks received on average lowest scores for their governance of climate-risk stress testing and the highest scores regarding their future plans on improving data collection and enhancing methodological and personnel capabilities.
Lack of integration of climate risk stress testing in the ICAAP and the bank-wide stress testing framework, as well as neglecting its outcomes in business strategy implementation and loan origination processes are main shortcomings identified by supervisors. Lack of transparency regarding Pillar 3 disclosures, validation and review of the climate stress testing framework are also considered as poor practice.
Another important insight is that the dependency of banks’ income on carbon-intensive activities is higher than average compared to other economic sectors, which implies the urgent need for banks to disinvest and reduce these exposures to become driving force in decarbonisation of the economy. The income dependency on high-intensity sectors shows also that transition risks are to be material. The Scope 3 emissions have been identified as dominant driver of carbon intensity, which are currently estimated by proxies.
Overreliance on proxies and estimations = underestimation of climate risk
The bottom-up stress test performed by only 44 of supervised banks covered three different scenarios for transition risk and two for physical risk:
1) Orderly – fluent transition according to NGFS net zero 2050
2) Disorderly – delayed transition
3) Hot House World – no transition based on current policies
4) Extreme floods
5) Long heatwaves
A novelty in the simulation of losses is that banks were required to incorporate long-term strategies over the next 30 years. However, the isolated effect of targeted climate-related shocks did not consider any other macroeconomic developments (such as an economic downturn).
The results show a definite high vulnerability to transition risks in the short term through an increase in impairments. Bank losses under the delayed transition proofed to be significantly higher than losses under the orderly transition and equal to losses under the hot house world scenario. This indicates how important is the adequate policy action and bank’s strategy towards smooth and timely transition of the economy.
A huge challenge for banks is the incorporation of long-term scenarios in their existing models and translation of scenarios into credit risk parameters (such as PD and LGD). Most of the risk variables are captured by proxies or limited to one transmission channel, without accounting for asymmetric sectoral effects.
These methodological limitations and the narrow scope of scenarios and exposures covered in the ECB climate stress test lead to significant underestimation of the actual risk for banks.
Towards the end of 2022 the ECB is going to provide a comprehensive set of best practices for climate-risk stress testing to be adopted by the broader financial sector (also institutions not in scope of the supervisory stress testing).
Recommendations from identified best practices:
• integrate climate risks into ICAAP supported by a good governance framework
• develop models at sector or firm level to account for heterogeneity in corporate sector
• allow for the joint integration of transition and physical risks
• engage with customers to retrieve climate-relevant counterparty-level data
• use actual data for emissions (full scope 3), energy efficiency and transition plans at counterparty level
• allocate income and exposures by sector and by emission intensity using counterparty-level data
• elaborate plans which include concrete green transition targets and KPIs
Given the multidimensional challenges faced by significant financial institutions regarding the data, governance and modelling of climate-related risk with the stress testing framework, considerable efforts in enhancing capacity and knowledge are required.
Do you need help for Climate Risk Stress Testing in your institution?
Together with my partner network I am working on solutions for financial institutions on how to design and implement comprehensive and tailored-made stress testing framework.
Our offering includes:
Scenario design: Business model analysis, risk drivers and narrative development
Model development: Definition of data requirements, development of assumptions, paramaters and calculation logic
Execution: Performing of climate stress tests, reporting and results interpretation
Integration: Support in integration of climate stress test in existing frameworks such as ICAAP
Roadmap: Development of action plans and relevant KPIs
Trainings: Provision of topic specific workshops on climate risk management and stress testing
We can tailor our offering to your needs, where necessary, leveraging the subject-matter experts from our network.
