Frankfurt natural disasters and climate change can trigger dangerous chain reactions in the financial system. This applies above all in the event of a disorderly transition to a climate-neutral economy. This is the assessment of the ECB and the European Systemic Risk Board (ESRB) in a report published on Tuesday.
The ECB and ESRB are keeping an eye on possible upheavals on the financial markets that could be triggered by natural disasters such as floods, heat waves and forest fires. “A climate shock could lead to a sudden repricing of climate risk, triggering a fire sale, in which financial institutions (…) quickly sell large numbers of affected assets simultaneously at severely depressed prices,” the report said.
This market price shock would initially hit the portfolios of mutual funds, pension funds and insurers. In a second step, such sudden price effects on the financing costs of companies could result in companies being affected become insolvent. This in turn would lead to bank defaults, according to the analysis by the ECB and ESRB.
The ECB has long been concerned with the impact of climate change on the financial world. In July, the central bank published the results of a stress test among banks in the euro zone. In addition to banks, the current analysis also includes other financial players such as funds or insurance companies.
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For example, a disorderly transition to a carbon-neutral economy can result in an abrupt and marked rise in carbon prices. For insurers and investment funds, this could potentially lead to market price losses of three to 25 percent of the assets under review in the short term.
Orderly economic restructuring can mitigate price shocks
An orderly restructuring of the economy towards climate neutrality by 2050 could mitigate such shocks. According to the ECB, the probability of corporate bankruptcies by then would drop by 13 to 20 percent compared to continuing today’s policies. This would also reduce banks’ losses from defaults.
A climate shock could lead to a repricing of climate risks.
(Photo: Daniel Hofer/laif)
In their report, the ECB and ESRB also deal with the question of which measures could be used to regulate climate risks in the financial world. For the banking industry, for example, there are still no suitable instruments, but some existing instruments could be easily adapted.
This applies, for example, to the so-called systemic risk buffer. This is a capital surcharge that banks would have to raise in addition to their required capital adequacy. However, this capital buffer is not aimed at risk concentrations that exist at individual banks, but is an instrument that would target the systemic risk of climate change in a very general way.
In addition, bank supervisors could introduce caps that prevent banks from becoming too heavily involved in certain carbon-intensive industries. The central bank also considers measures aimed at bank customers to be promising, for example when it comes to real estate loans for apartments in areas that could potentially be affected by natural disasters.
Bundesbank publishes parts of its own CO2 footprint
A major problem for the ECB is that there are still no mature models that can be used to precisely calculate the burden of climate risks. For example, 41 selected banks had calculated that various climate scenarios would probably lead to market price and credit losses of 70 billion euros. From the ECB’s point of view, however, this sum still underestimates the actual scope of damage from such developments.
The Bundesbank, meanwhile, reported on Tuesday about progress in measuring its own carbon footprint. In its first climate report, the German central bank presented, among other things, calculations on the greenhouse gas balance and other climate indicators for parts of its investments, as it announced. She examined her own investments and not the securities purchases that serve monetary policy purposes.
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The portfolio, which had a market value of EUR 10.4 billion at the end of December 2021, currently consists exclusively of Pfandbriefe and Pfandbrief-like securities. Banks use covered bonds to borrow money cheaply from investors, since these securities are additionally secured by real estate loans or government bonds that these banks own. However, the Bundesbank’s analysis only examined the issues of the banks that issued the covered bonds.
The Bundesbank did not calculate the greenhouse gases that were financed by the real estate loans of these banks. According to the central bank, there is still insufficient data for this. The CO2 footprint of 0.13 tons of CO2 per one million euros investment calculated by the Bundesbank is probably too low, according to the central bank itself.
After all, the “green” share of the Bundesbank’s euro portfolio, which is used to finance renewable energies or energy-efficient buildings, is just under two percent, well above the values of the most important European commercial banks, which come to 0.4 percent. The environmentally harmful “brown” share is 0.1 percent at the Bundesbank, compared to 0.8 percent at commercial banks.
More: Climate stress test: ECB criticizes banks’ inadequate handling of climate risks