Have you heard of the ECB Climate Stress Test? The European Central Bank’s (ECB) Climate Risk Stress Test (CST) for the financial sector was introduced earlier this year and it was created to examine whether European banks understand, and are set up for climate risk. The test is a crucial element in planning for climate change response.
How does it work?
The test helps to ascertain issues in EU regulation that may need resolving, assisting the financial industry with the implementation and management of climate risk strategy. This includes mentoring best practices in the sector when planning for future climate change events. The test has been designed to strengthen regulation and increase climate resilience.
What are the components of the test?
The test consists of three modules and each module uncovers a different element of how financial institutions are combating climate change risk. Modules one to three include a qualitative questionnaire analysing how institutions are addressing climate risk management, a peer-comparison review, measuring each bank using climate metrics, and finally, the assessment of physical risk damage from climate events – with a focus on transitional risks (the risk inherent in changing strategies, policies or investments to reduce reliance on carbon).
The results from the last module are possibly the most enlightening. They highlight how the sector is preparing for climate risks. It looks at four areas: short-term transition risk, long-term transition risk, short-term drought, and heat physical risk, and short-term flood physical risk.
The results for 2022
The test highlighted some notable key findings and The Financial Times highlighted how Eurozone banks are underestimating the hit from climate change. For example, the surprising fact is that most banks do not consider climate risk in their credit risk pricing or their risk management models at all. The results go on to highlight a host of pitfalls in the financial sector. Such as, only one in five banks consider climate risk when authorising loans and 60% of the participating banks (41 European banks) do not yet have a climate risk stress testing framework in place. The hard truth is credit and market losses amount to around €70 billion on aggregate for the 41 banks.
What needs to change?
What can regulators take away from the test results? Overall, the financial sector needs to develop robust climate stress testing systems, procedures, and frameworks – it must happen now in order to make a difference.
Banks rely heavily on proxies to estimate their exposure to emission-intensive sectors and that makes them vulnerable to transition risks. The sector needs to improve the robustness of these proxies and they need to step up in engagement with their customers and collect relevant data from their customers directly.
There is some good news though: some banks are already on the right track. They have managed to collect direct data from customers for at least 90% of their reported income. This is encouraging but more actions need to be taken immediately.
Why banks and institutions must harness asset-level climate intelligence
The 2022 Climate Stress Test performed by the European Central Bank addresses wider, and to a large extent qualitative, aspects of stress testing rather than simply looking at quantitative results. The credit and market losses that amounted to around €70 billion, were an understated cost that wasn’t accompanied by broader economic downturns and was limited to specific portfolios of the 41 participating banks.
Partha Bose, Head of Capital Markets at Cervest says: “The only way for institutions to accurately and completely assess their financial risk exposure to climate hazards, is to integrate best in class, asset-level climate intelligence, that includes spatial and multi-hazard correlations, into the existing suite of modelling and stress testing solutions.
To reach this level of accuracy regulators must encourage banks to adopt climate intelligent technology. Banks and other financial institutions should also ask their clients for more detailed asset-level climate risk disclosure, in the same way that they would expect them to disclose other potential sources of risk in order to obtain loans or access capital. This will lead to climate risk being incorporated in decision workflows at a transaction level, and will help banks develop robust climate stress testing frameworks, leading to more rigorous and relevant bottom-up stress tests that can be performed on a regular basis.”
The integration of the best climate intelligence in the financial sector is a way for the market to clearly see future climate risks and detail their strategies accordingly. We believe this type of granular data over varying timelines can equip the industry with the deep knowledge required to act on climate change plans – now.
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