The financial sector will suffer significant declines if the climate transition does not proceed in an orderly fashion. Abrupt climate risk revaluations will hit banks, asset managers and insurers particularly hard.
Losses in financial markets due to abrupt climate risk revaluations can hit investment funds and insurers hard. It can lead to defaults by companies and cause credit losses for banks. If we fail to ensure an orderly green transition, the risks will spread quickly throughout the financial sector, with companies and banks most at risk.
This is according to a joint report by the ECB and the European Systemic Risk Board (ESRB), entitled The macroprudential challenge of climate change (see annex). The risks of eurozone banks remain particularly pronounced, especially in the exposure of loans to climate-relevant sectors such as mining, manufacturing and electricity. The loan-weighted emission intensity of exposures to these sectors is still around 60 per cent of the total, according to the report.
ECB/ECSR: The macroprudential challenge of climate change
An orderly transition to net zero emissions by 2050 could mitigate price shocks and reduce chances of corporate default by 13 to 20 percent. It would also reduce credit losses for banks.
Price increases
Among other things, a carbon price rise increases the likelihood of an accumulation of bankruptcies. A disorderly sharp rise in carbon prices could result not only in a fivefold increase in risk-weighted assets, but also in a near doubling of the average default correlation. This correlation measures whether assets with high credit risk are more likely to default together or separately. According to the report, this suggests that protection through diversification is of limited relevance.
While this is particularly true for high-carbon-emitting firms, it can also affect less carbon-intensive market participants, according to the study.
According to the ECB and ECST, market dynamics can also increase the financial impact of physical risks. ‘For example, a climate shock could lead to a sudden re-pricing of climate risk, triggering panic selling, with financial institutions rapidly selling a large number of exposed assets at low prices at once.’
Unforeseen climate shocks in such a case could hit the portfolios of investment funds, pension funds and insurance companies hard. In a disorderly transition scenario, characterised by an immediate, significant increase in carbon prices, insurers’ and asset managers’ mutual funds’ short-term losses could reach 3 and 25 per cent of stress-tested assets respectively.