Usefulness of the article: Understanding the context surrounding the introduction of climate stress tests within the European Central Bank and learning about its main predictions for 2050 regarding the impact of global warming on businesses and the banking sector.
Summary:
- Due to its mandate to maintain price stability and its secondary objective of protecting and improving the quality of the environment, the European Central Bank (ECB) must address climate issues and thus participate in the transition to a zero-carbon economy.
- The first climate stress tests published by the ECB in September 2021 state that, in the absence of new transition policies, global warming could have an impact of up to 10% on European gross domestic product (GDP) by 2100.
- Given the irreversible nature of global warming, the ECB emphasizes that physical and transition risks pose a significant threat to non-financial companies and banks, and warns supervised entities of the non-linear growth of losses in the event of inaction in the face of global warming.
Faced with the need to take action against global warming and given the growing demand for urgent public intervention, the principle of central bank neutrality is often criticized. The main argument put forward by central banks to justify their relative inaction was that climate issues went beyond their remit and that, consequently, addressing this issue would lead to the « politicization » of their supposedly neutral interventions—so as not to favor certain sectors of the economy at the expense of others—and a « shift » in their mandates (mission creep).
I – Central bank interference in climate issues
Given the threats that climate risks pose to their primary and secondary objectives (price stability, financial stability, full employment, growth, etc.), the principle of central bank neutrality no longer seems justified to certain stakeholders. More and more agents—companies, banks, insurance companies, and asset managers—are now directly or indirectly exposed to physical risks (floods, droughts, fires, etc.) and transition risks (asset depreciation, loss of insurance contracts, etc.) that can lead to negative supply shocks, price increases, and slowdowns in activity. In turn, liability risks (potential lawsuits and compensation payments by legal entities deemed responsible for the consequences of global warming) may increase systemic risk in various sectors and, given the potential for knock-on effects, pose a threat to financial stability.
In the case of the European Central Bank (ECB), its primary mandate is based on price stability and is therefore not directly concerned with climate issues. However, among its « secondary » objectives is the obligation to support the general economic policies of the Union, including « a high level of protection and improvement of the quality of the environment » (see Art. 3.3 and Art. 21.2.f of the Treaty on European Union). In this sense, the Governor of the Bank of France, François Villeroy de Galhau, stated in a speech on February 11, 2021: « The Eurosystem’s consideration of climate change is neither an abuse of its mandate, nor a simple militant conviction or a fad; it is an imperative that we must pursue in the name of our current mandate and to ensure the proper implementation of monetary policy.«
Dutch central banker Frank Elderson, current chair of the Network for Greening the Financial System (NGFS), stated in an opinion piece published on February 13, 2021, that the effectiveness of monetary policy could be hampered by the consequences of climate-related structural changes. However, he pointed out the ECB’s room for maneuver on climate issues: « We must not encroach on the remit of other authorities responsible for environmental policy, at EU or national level […]. We must contribute to the success of climate change policies, but we cannot formulate them ourselves. »
For his part, the President of the Deutsche Bundesbank, Jens Weidmann, although a fervent advocate of the need to take action on global warming, similarly pointed out in a speech at Goethe University in Frankfurt on January 25, 2021[5]: « It is not the role of independent central banks to correct or replace political decisions. Our independence was not granted to us so that we could make the decisions that politicians are unwilling to make […]. An active role in climate policy could undermine our independence and ultimately compromise our ability to maintain price stability. »
Beyond the differing opinions on the level of interference by central banks in climate issues, it seems essential to integrate climate risks in order to better cope with disasters known as « green swans, » i.e., certain climate events with considerable or extreme impacts and irreversible consequences, the timing, location, and nature of which cannot be accurately predicted. The term « green swan » derives from the concept of the « black swan. » The latter, developed by Professor Nassim Nicholas Taleb in 2007, refers to unexpected and rare events with significant or extreme impacts that can only be rationalized in retrospect. In the case of « green swans, » unlike black swans, the events are exclusively climatic, expected, and irreversible. While it is not possible to predict the magnitude of a « green swan, » its economic and social consequences are assumed to be systemic.
However, the ECB is currently exposed to climate risks due to its balance sheet containing securities purchased and assets taken as collateral associated with carbon-intensive activities, for which a lack of standardized information and harmonized metrics prevents fair pricing. A requirement for transparency on the part of agents in order to better understand climate-related financial risks and, at the same time, to integrate these risks appropriately into central bank operations is therefore imperative for maintaining financial stability and the smooth transmission of monetary policy.
II – The role of climate stress tests
The adoption of a forward-looking approach through the analysis of climate scenarios with appropriate time horizons – so as not to « fall into the trap » of the « tragedy of horizons »[7] – is becoming increasingly necessary thanks to stress tests. These tests assess the financial health of an agent by analyzing its capitalization and the quality of its assets in order to determine its ability to cope with potential losses resulting from a recession or financial crash. Stress tests can also be used for macroprudential purposes to measure potential impacts on the financial stability of a system as a whole. The results then enable supervisory authorities to identify vulnerabilities among market participants in order to prevent major negative consequences in the event of a shock. In the specific case of climate stress tests, the assessments measure an agent’s resilience to climate shocks that could arise from different ecological transition scenarios and do not, as yet, have any consequences in terms of regulatory capital.
On September 22, 2021, the ECB published a report on the results of its first climate stress tests. Using a top-down analysis method and a database of four million companies worldwide and 1,600 banks in the 19 countries of the eurozone, the exercise consisted of assessing the impact of three climate scenarios from the NGFS:
1) An « orderly » transition involving gradual reductions in greenhouse gas emissions aimed at meeting the temperature targets set out in the Paris Agreement signed at COP21 in 2015, which aims to limit global warming to a maximum of 2°C above pre-industrial levels (1861-1880) by the end of the 21st century[10].
2) A so-called « disorderly » transition, corresponding to a scenario of delayed response where a policy to mitigate global warming would not be put in place until 2030 and where measures would be more proactive.
3) A « hot world » scenario, where no regulation or limitation on additional global warming would be introduced and where the probability of physical risks would be extremely high, with an expected increase of around 3°C by 2100.
The macroeconomic benefits of the transition
The main conclusion is hardly surprising: an orderly and rapid transition would minimize short-term costs and maximize long-term benefits. Although European gross domestic product (GDP) growth is expected in all three scenarios, the estimated impact of global warming differs in each case. By 2100, the ECB estimates that the impact on European GDP would be up to 2% in the event of a disorderly transition and up to 10% in the absence of new mitigation policies compared to an orderly transition.
Inaction as a source of risk for the banking sector and businesses
Global warming could represent a significant source of systemic risk for banks with portfolios concentrated in carbon-intensive economic activities subject to high transition risk or located in geographical areas subject to high physical risk, particularly in the case of institutions established in countries where regulatory protection of collateral is weak.While the report notes that most banks in the euro area have relatively similar exposure to transition risk, the exposure of their loans to physical risk varies greatly depending on their location, as southern European regions are subject to high fire risk and central and eastern European countries are more vulnerable to flooding. As a result, the balance sheets of banks located in countries such as Greece, Cyprus, Portugal, Spain, and Malta are much more exposed to companies that are vulnerable to physical risk.
In addition, the report emphasizes the irreversible nature of global warming and, in the event of inaction, the non-linear growth in losses that would result. According to its estimates, in the absence of new transition policies, company profitability by 2050 would be 40% lower than in the case of an orderly transition, particularly due to the decline in revenue caused by physical risks (direct or indirect via impacts on their production chain) and the increase in operating costs due to transition risks (carbon tax, conversion to low-carbon technologies, etc.). Furthermore, the probability of corporate default by 2050 would be 2.5% higher in the event of a disorderly transition and 5.5% higher in a « hot world » scenario.
Furthermore, given that a significant portion of eurozone banks’ collateral consists of physical guarantees, banking institutions are highly exposed to physical risks under a « hot world » scenario.Losses given default in bank portfolios are therefore unevenly distributed and appear to be more significant in regions highly exposed to physical risks. Consequently, the ECB estimates that, in the absence of new mitigation policies, losses in the banking sector could be 8% higher than in an orderly transition scenario.
Future developments in the ECB’s climate stress tests: the 2021 exercise as afirst step in the ECB’s climate roadmap
In order to improve its forecasts, the ECB plans to publish new climate stress tests in 2022 which, unlike these initial estimates based on assumed static bank balance sheets, will analyze the profitability and solvency of dynamic bank balance sheets that incorporate feedback loops between banks and the real economy. This development would be in line with the methodological choices made by the ACPR in its pilot exercise conducted in 2020-2021, the results of which were published in spring 2021[13]. Emphasis will also be placed on banks’ resilience to changes in the solvency of their counterparties. It should be noted that the ECB also plans to measure the impact of global warming on households, sovereign portfolios, and non-bank institutions.
Conclusion
Regardless of the various climate scenarios, the long-term benefits of an orderly transition to a low-carbon economy appear to largely offset the short-term costs and reduce the probability of corporate and bank defaults in the medium and long term. Although the ECB’s role as a whistleblower was necessary, it remains insufficient. In addition to criticism of the ECB’s principle of neutrality and calls for it to adapt its monetary policy, many are demanding that it decarbonize its balance sheet and quickly implement stricter regulations on bank support for projects that are not aligned with the objectives of the Paris Agreement. Although the ECB is becoming increasingly sensitive to climate issues, it still does not seem sufficiently « stressed » by the urgency of the matter.
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[1]Article 127 of the Official Journal of the European Union states: » Without prejudice to the objective of price stability, the European System of Central Banks shall support the general economic policies […] with a view to contributing to the achievement of the objectives of the Union. » See: https://eur-lex.europa.eu/legal-content/en/TXT/HTML/?uri=CELEX:12016E127
[2]https://eur-lex.europa.eu/resource.html?uri=cellar:2bf140bf-a3f8-4ab2-b506-fd71826e6da6.0002.02/DOC_1&format=PDF
[3]https://www.banque-france.fr/intervention/le-role-des-banques-centrales-dans-le-verdissement-de-leconomie
[5]https://www.bundesbank.de/fr/presse/discours/quel-r%C3%B4le-pour-les-banques-centrales-dans-la-lutte-contre-le-changement-climatique–857926
[6]https://publications.banque-france.fr/sites/default/files/medias/documents/820155_bdf229-8_cygne-vert_vf.pdf
[7]In the face of climate threats, the concept of the « tragedy of horizons, » detailed by former Bank of England Governor Mark Carney in his speech on September 29, 2015, refers to the risks associated with the time lag between the financial sector’s pursuit of short-term profits and the need for long-term sustainable financing for society as a whole in the context of a transition to a low-carbon economy. See: https://www.bankofengland.co.uk/-/media/boe/files/speech/2015/breaking-the-tragedy-of-the-horizon-climate-change-and-financial-stability.pdf?la=en&hash=7C67E785651862457D99511147C7424FF5EA0C1A
[8]https://www.ecb.europa.eu/pub/pdf/scpops/ecb.op281~05a7735b1c.en.pdf?278f6135a442cd0105488513e77e3e6d. Climate stress tests with shorter time horizons and smaller samples have already been conducted within the European Union by the Bank of the Netherlands in 2018, by the Prudential Control and Resolution Authority and the Bank of France in 2020, and by the Bank of England and the European Banking Authority in 2021.
[9]https://www.ngfs.net/sites/default/files/medias/documents/820184_ngfs_scenarios_final_version_v6.pdf
[10]https://unfccc.int/files/essential_background/convention/application/pdf/english_paris_agreement.pdf
