The European Central Bank released a report on July 8, 2022, detailing the results of a climate stress-testing exercise performed on its member banks. The purpose of the exercise was to evaluate the ability of these institutions to withstand climate change financial risks, including exposure to physical assets and transition risk.
The report found that only 42% of the participating banks had integrated climate change into their balance sheet management practices. The results of this exercise will likely serve as a benchmark for other central banks around the world.
Central banks seek incorporation of climate risk factors in financial stress tests
The ECB assessed its member banks' ability to withstand climate change financial risks. It revealed that only 42% of participating banks have integrated climate change into their balance sheet management.
The ECB’s report also highlighted the need for additional transparency in reporting and assessing emissions, dependence on fossil fuel-heavy sectors for revenue and the use of inaccurate proxies in the bottom-up modeling of climate risks.
The ECB projected aggregate losses of €70 billion over three years for participating banks and warned that losses would likely be much higher in affected areas.
On the regulatory side, the EU has adopted measures to not just facilitate decarbonization, but also preempt so-called ‘carbon leakage’ through the introduction of the carbon border adjustment mechanism (CBAM), which aims to level the playing field between EU and foreign companies.
CBAM will have business implications for companies that import products covered by CBAM, namely steel and iron, aluminum, cement, fertilizers and electricity, as well as hydrogen and certain categories of indirect emissions.
CBAM will enter into force on October 1, 2023, but with importer obligations being restricted to reporting until 2026. From 2026 through 2034, CBAM will be gradually phased in, requiring affected companies to buy certificates that cover CO2 emissions linked to production.
The Network for Greening the Financial System is an organization that includes most of the world's largest central banks. Its purpose is to facilitate the sharing of information regarding the risks arising from climate change and how these risks affect financial stability. This could potentially lead to greater consistency and standardization across economies for managing climate risk.
Other central banks, including the People's Bank of China and the Bank of England, have also run climate stress tests on their banking systems. However, the rigorous nature of the ECB stress tests may inform not only other climate stress tests, but also the way climate risk is managed in the financial sector overall.
Mounting climate risks call for prioritizing capital to adaptation over simple mitigation
Previous UN conferences on climate change have focused on reducing greenhouse gas emissions to limit the damage from climate change. While the Paris Agreement and subsequent conferences aimed to implement this goal, many issues remain unresolved.
When global governments gathered in Egypt for the UN Climate Change Conference in November 2022, it became clear that the awareness of physical climate risk had increased. Extreme weather events are now commonly attributed to climate change, and financial companies, such as insurers, banks, asset managers and private equity firms, are all trying to account for and manage physical climate risk.
Reflecting the need for mitigation and the sustained focus on physical climate risk, the Conference of the Parties (COP) to the UN Framework Convention on Climate Change featured discussions on adaptation finance. Adaptation finance, a feature of COP for decades, is ordinarily used to absorb the impact of increased emissions that cannot be reduced quickly.
The availability of minor public or blended finance capital allocations to private companies in developing economies could reorient local business ecosystems around climate-responsive infrastructure and supply chains.
In the recent COP28, held in Dubai, United Arab Emirates from Nov. 30 to Dec. 13, 2023, world leaders committed to triple renewable capacity and double energy efficiency by 2030 based on a historic text that was part of the first-ever Global Stocktake (GST).
Attracting Adaptation Capital
Developing economies facing the need to finance infrastructure hardening and other adaptation projects are competing for resources with developed economies dealing with their own financing needs because of the increasing frequency and magnitude of weather and climate-related disasters.
The US National Oceanic and Atmospheric Administration reported that between January and July 2022, the US had nine weather and climate-related disasters, each with losses of more than $1 billion. Last year, there were 20 such events that cost a total of $152.6 billion.
Although industrialized countries are responsible for a large share of emissions that cause environmental damage, it is challenging to convince domestic political audiences to provide funds to developing economies to address the damage.
However, the public perception of adaptation has an advantage that mitigation never had. The share of the global population that has firsthand experience of the aftereffects of extreme weather events is no longer concentrated in the Global South. This has led to more people in more countries wanting better protection.
The drive for adaptation carries a sense of urgency that mitigation never could, in that the associated physical risk is visible and quantifiable.
At the 2023 United Nations Climate Change Conference (COP28), creative finance was discussed mostly in the context of encouraging private investment in climate solutions and help drive energy transition in developing countries. There was progress seen at COP28 with the activation of the Loss and Damage fund. This was a funding mechanism designed to help developing countries facing climate change events like droughts and floods to cope with climate impacts.
If a country, developed or developing, offers incentives that allow investors to expect a strong rate of return on adaptation-linked investment projects, particularly if the investments are backed by loan guarantees or other risk-reduction tools by multilateral financial institutions, these incentives could offer healthy inducements to investors looking for the right mix of climate consciousness and returns.
A Climate Risk-filled Future
In summary, climate change presents a significant challenge to the global community, and its impact is being felt with each passing year. The financial sector has a crucial role to play in helping to mitigate the risks of climate change, and it is heartening to see that many central banks and financial institutions are taking action to address this critical issue.
However, much work remains to be done, and it is vital that all major players from various industries continue to build on the progress achieved so far. By working together and adopting a comprehensive, collaborative approach, a more sustainable and resilient future can be realized for future generations.
