Climate change and the transition to net zero carbon emissions pose risks to households and firms, and therefore to the financial sector. Accordingly, exposure to climate-related and environmental risks is among world leaders’ strategic priorities.
As a competent authority, the European Central Bank (ECB) is required to carry out annual stress tests on supervised entities. In 2022, the ECB carried out a climate risk stress test among the significant institutions as its annual stress test.
The exercise was carried out to assess the internally built climate risk stress-testing capabilities of the banks in scope. Specifically, it explored:
- the progress banks have already made in developing climate risk stress-testing frameworks;
- the capacity of banks to produce climate risk factors, an intermediate step towards developing climate risk stress test estimates;
- the capacity of banks to produce climate risk stress test projections;
- the risks banks are facing in the form of transition risks (both short-term and long-term) and acute physical risk events.
The exercise showed that banks have made considerable progress with respect to their climate stress-testing capabilities. At the same time, the exercise also revealed many deficiencies, data gaps and inconsistencies across institutions. Against this background, the ECB expects banks to make substantial further progress in the coming years.
Overall, banks have started to integrate climate risk into their stress-testing frameworks. Nevertheless, most supervised institutions are still at a very early stage in the development and implementation of such frameworks. Around 60% of banks do not yet have a well-integrated climate risk stress-testing framework, and most of those banks envisage a medium to long-term time frame for incorporating physical and/or transition climate risk into their framework.
Finally, while acknowledging the many challenges banks are facing about climate risk stress testing, the exercise showed that in each of the assessed areas, at least some of the banks were able to address the challenges in a satisfactory manner, suggesting that it is possible for the industry to raise the bar across all the areas assessed. In this light, the ECB plans to follow up on the findings with bank-specific recommendations and guidance on best practices in climate stress testing. The focus will be on helping banks to build their internal climate risk stress-testing frameworks and overcome the current challenges.
Source: European Central Bank