An abrupt and disorderly transition to a low carbon economy risks disrupting the financial system as a sudden implementation of climate change mitigation policies can increase transition risks, a new European Central Bank study said on Friday.
The ECB’s researchers raised the prospect of “severe banking system losses” if no additional policy action is taken. These losses could reach “up to 40 percent more” compared to a baseline scenario where no policy action is taken.
“If not well addressed and measured, an abrupt and disorderly transition can have repercussions on the financial system,” the ECB said in a working paper on the sensitivity of banks to carbon prices.
‘Weaken stability’
“The transition to a greener economy might put some firms out of business and lead others to the brink of bankruptcy. Banks, as a consequence, can face losses through their exposures to these firms, which can weaken the stability of the financial system.”
The ECB study analysed data that covers some 23.8 trillion euro in lending exposures, from roughly 1900 banks. Approximately 35 percent of these exposures, or 7.4 trillion, is classified as large exposures - accounting for more than 10 percent of bank capital - and around 40 percent of these can be considered as climate policy relevant.
Sudden changes in carbon prices are critical for determining how the financial system will react to the energy transition, said the ECB. “The impact of the carbon price increase on firms’ likelihood to default depends on the level of carbon emissions produced by each firm, on their leverage ratio, and on their ability to pass carbon prices onto their customers.”
‘Disruptive effects’
“A disorderly, abrupt transition to a low carbon economy requiring very high sudden changes in carbon prices might have disruptive effects on the financial system, especially if firms fail to reduce their emissions,” the ECB said.
The ECB’s researchers said that banks may have to restrict their lending to less polluting firms, lend to firms with ambitious emissions reduction targets or help firms in transitioning to low carbon business models.
“Policy measures are pivotal to require firms to disclose the direct and indirect emissions produced, as well as verifiable strategies to reduce them. Policy measures should target banks too, which should disclose not only their carbon footprint, but especially the climate risks connected to their exposures.”
Carbon prices volatile
Furthermore, the ECB said regulators need to implement further prudential measures to prevent the build-up of banking system losses or pockets of risks through bank exposures to firms not adapting to a greener economy.
The ECB analysis did not take into account the consequences for Europe’s energy transition of Russia’s invasion of Ukraine.
In the European Emissions Trading system, carbon prices have fallen sharply following Russia’s invasion of Ukraine. After reaching a peak of 96.93 euro per ton on 7 February, they traded as low as 58 euro per ton on Wednesday as some carbon traders were said to be required to liquidate positions to cover margin calls. By Friday, carbon prices had recovered to about 80 euro per ton, double the price of about 40 euro per ton one year ago.
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