Climate change risk: Demands and expectations imposed on banks

Abstract

For several years, there has been discussion about whether climate change risk is a fundamentally new type of risk or can be subsumed under market, credit, operational and systemic risk in the financial industry. The European Central Bank’s current ‘climate risk stress test’ is a milestone marking a shift in that discussion, from a normative one to a perspective on actual exposures and quantitative data. This shift is linked with regulatory guidelines about how climate change risk should be integrated into banks’ risk frameworks, but also comes with some expectations for banks to actively steer funding to the green transformation. We now understand climate change better than ever and are able to estimate the physical damages it will cause (ie the estimated probability distribution of damages from additional ‘extreme events’). This can be mapped to credit exposures by region (eg river valleys) and by industry segment (eg agriculture) as elaborated in the ‘climate risk stress test’. This paper provides a first step for extending the approach from actual exposures to expected losses by comparing the effects of ‘normal’ weather events with the additional climate-change-related events. However, sophisticated models are required to separate the climate-change-related excess of rare but severe events from extreme weather events that are not related to climate change. In contrast to the earlier static concept of ‘stranded assets’, a ‘transition risk’ would be the result of ‘disorderly’ pathways to a low carbon economy rather than a transparent and consistent road map. A sudden and abrupt increase in the price of carbon (or of greenhouse gas emissions in general) would travel along a transmission chain in the economy, eventually affecting banks’ credit and market risk exposure. Determining the effect of such a step function on an estimated loss distribution is methodologically challenging, especially because there are limited data on historical events. The actual transmission will be even more complicated as political decisions interact with social acceptance and there is a (new) risk of the lack of societal consensus. This paper discusses this challenge, using a schematic model of the political decision on and societal reaction to carbon prices and the consequences for carbon-intensive industry sectors and consumers and citizens. Finally, regulators have expectations of how banks should contribute to a ‘green deal’ and bridge the gap between political commitments and economic measures. This task for the financial services industry — ‘steering credit’ — turns out to be a new source of risk for the societal ‘licence to operate’, into which more insight is required. This paper disentangles the various elements as a step towards a better understanding of the challenges that climate-changerelated risk poses to banks.