European Central Bank’s Climate Risk Stress Test

Following the adoption of the Paris Agreement and the UN 2030 Agenda for Sustainable Development in 2015, governments are making strides to transition to low-carbon and more circular economies on a global scale. This transition entails both risks and opportunities for the economy and financial institutions, while physical damage caused by climate change and environmental degradation can have a significant impact on the real economy and the financial system. For the second year in a row, the European Central Bank (ECB) has identified climate-related risks as a key risk driver in the Single Supervisory Mechanism (SSM) Risk Map for the euro area banking system. As a consequence, within the ECB supervisory stress testing framework, the ECB conducts for the first time a climate risk stress test in 2022. Xavier Scholten, part of the Spuerkeess ESG Team and Climate Finance Expert at Spuerkeess takes on the challenge of demystifying the ECB’s latest Climate Risk Stress Test.

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1. Xavier, what is the objective of the ECB’s Climate Risk Stress Test ?

The European Central Bank’s industry-wide climate stress test sits alongside a wide range of former climate stress-testing initiatives executed by different European and international institutions (among others by De Nederlandsche Bank (DNB), Banque de France (BdF) and Bank of England (BoE)). While there are similarities, the European Central Bank (ECB) exercise intends to improve on past initiatives by introducing significant innovations in terms of data and modelling, being the first climate stress test to capture certain interactions of physical and transition risks. The main objective of the climate stress test consists in assessing how prepared banks are for dealing with financial and economic shocks stemming from climate risk.

For this purpose, the ECB refers to various climate scenarios that were developed in cooperation with the Network for Greening the Financial System (NGFS). The climate scenarios provide a range of data on transition risk, physical risk and the related economic and financial impacts. Each scenario explores a different set of assumptions for how climate policy, emission pathways and temperatures evolve.

2. Why did Spuerkeess take the test?

In response to the financial crisis, the EU Council and the European Parliament entrusted the European Central Bank with supervisory tasks. The ECB acquired these tasks in addition to its monetary policy function. This led to a direct supervising by the ECB of the 115 most significant banks from the euro area banking system. As a competent authority, the ECB is expected to carry out annual stress tests on supervised entities in the context of its Supervisory Review and Evaluation Process. Spuerkeess, being part of the group of significant banks in the euro area, annually participates in the ECB’s stress test. As already mentioned in the first question, a supervisory climate risk stress test has been added this year to assess Spuerkeess’ climate-risk preparedness.

3. What can you tell us about the methodology of this stress test?

The exercise consists of three distinct modules:

(1) a qualitative questionnaire on banks’ internal climate stress test capabilities,

(2) an assessment of banks’ transition risk exposure (sustainability of banks’ business models and their exposure to emission-intensive companies), and

(3) a bottom-up stress test.

To ensure the proportionality of the exercise, smaller banks will not be asked to provide their own stress test projections. Thus, as a module 2 bank, Spuerkeess is required to submit different data templates containing the modules 1 and 2 as well as the starting point values of module 3. The official start of the climate stress test with the publication of the methodology and templates was in June 2021. The execution phase of the data collection process started on the 7th of March and involves 3 submission cycles. Currently we are in the third and last submission cycle and we released the final data templates in the last week of May. Thereafter, Spuerkeess will receive an individual output report in July and the ECB expects to publish aggregated results of the overall climate stress test by the end of July.

4. What has been the outcome of the stress test to date? What are Spuerkeess’ current strong points in the matter and where do you see us improving?

Since the 2022 climate stress test is the first in this form, it remains a learning exercise and it is not a pass or fail exercise. However, Spuerkeess expects that such climate stress tests will become more frequent in the future. One conclusion we can already draw is that such climate stress tests require new data which differ from the conventional financial risk data, and which are not yet sufficiently available today. Hence, a major challenge will be to collect this new type of data from our various stakeholders in the upcoming years. Given that climate stress tests are a rather new exercise for the financial sector, we will use this exercise to enhance our internal stress test framework and strengthen climate and environmental risk management. In particular, Spuerkeess intends to further deepen the Bank’s understanding of the impact of transition risks on traditional risk parameters. In addition, we aim to improve the assessment of national physical climate risks and their impact on the real estate portfolio in the future.