Report: Europe's banks must raise game on climate risk

Europe’s banks aren’t sufficiently considering risks from climate change and must “urgently step up efforts” to make sure they understand the possible impact of floods, wildfires and losses on investments.

That was a key conclusion from a climate stress test on 104 banks run by the European Central Bank and released Friday.

The ECB said that for now the climate stress test was a learning exercise that would not result in requiring banks to strengthen their financial buffers against possible losses from borrowers who can’t pay.

But the bank’s supervisory arm warned that as things stand now, 60% of the 104 surveyed banks have no framework for assessing the impact of climate risk on their financial solidity, and only 20% consider climate risk when granting loans.

Banks in southern Europe were more exposed to risks from heat and drought that could hit construction and agricultural businesses, the report indicated.

Banks “currently fall short of best practice” when it comes to assessing the risk that borrowers would not be able to repay loans due to climate−related incidents. It noted that almost two−thirds of bank income comes from corporations in industries that emit large amounts of carbon dioxide, leaving them vulnerable to loss as businesses have to shift to lower−emission production.

Banks have received feedback from the ECB and “are expected to take action accordingly” under the supervisor’s best practices guidelines. The ECB is the banking supervisor for the 19 countries that use the euro. Banks are key to keeping the economy running well because they are the primary source of credit and financing for businesses in Europe, a contrast to the US where more financing comes from financial markets.

The report said a smaller sample of 41 banks from the test would have suffered 70 billion euros in losses under a “disorderly transition” scenario in which the price of carbon emissions rises dramatically over a three year period.

The report said that banks would suffer lower losses if efforts to fight climate change were stepped up enough to keep the increase in global average temperatures to 1.5 degrees Celsius or less. Losses would be larger in scenarios under which efforts to limit the temperate rise were postponed and then drastically increased, or simply not undertaken. The ECB noted that banks “barely differentiate” between differing long−term scenarios that could affect their businesses.

The findings from the test will serve as “a compass" for banks to boost their awareness of climate issue and prepare for the risks and opportunities of a transition to net zero, that is, a situation in which any carbon dioxide emissions are small enough to be absorbed by the environment or abated through methods such as underground storage.