Report: European banks must step up their game on climate risk

FRANKFURT, Germany (AP) — European banks are not taking climate change risks sufficiently into account and must “urgently step up their efforts” to ensure they understand the possible impact of floods, wildfires and investment losses.

That was one of the key findings from a climate stress test of 104 banks run by the European Central Bank and released on Friday.

The ECB said that for now the climate stress test was a learning exercise that would not entail requiring banks to bolster their financial reserves against possible losses from borrowers who cannot pay.

But the bank’s supervisory arm warned that as things stand, 60% of the 104 banks surveyed have no framework to assess the impact of climate risk on their financial strength, and only 20% take take climate risk into account when granting loans.

Banks in southern Europe were more exposed to heat and drought risks that could hit construction and agricultural businesses, the report said.

Banks are “currently not following best practice” when it comes to assessing the risk of borrowers not being able to repay their loans due to climate-related incidents. He noted that nearly two-thirds of banks’ revenue comes from companies in sectors that emit large amounts of carbon dioxide, making them vulnerable to losses as companies have to switch to low-emissions production.

The banks have received comments from the ECB and “are expected to take action accordingly” under the supervisor’s best practice guidelines. The ECB is the banking supervisor of the 19 countries that use the euro. Banks are essential to the proper functioning of the economy as they are the main source of credit and financing for companies in Europe, unlike in the United States where more financing comes from the financial markets.

The report says a smaller sample of 41 banks in the test would have suffered 70 billion euros in losses under a “disorderly transition” scenario in which the price of carbon emissions would rise significantly over a three-year period.

The report says banks would suffer smaller losses if efforts to combat climate change were scaled up enough to keep the increase in global average temperatures to 1.5 degrees Celsius or less. Losses would be greater in scenarios in which efforts to limit temperature rise were postponed and then dramatically increased, or simply not undertaken. The ECB noted that banks “barely differentiate” between different long-term scenarios that could affect their business.

The results of the test will serve as a “compass” for banks to strengthen their climate awareness and prepare for the risks and opportunities of a transition to net zero, i.e. a situation in which all emissions of carbon dioxide are low enough to be absorbed by the environment or mitigated by methods such as underground storage.