Climate change and financial stability

Original report published by European Central Bank

Prepared by Margherita Giuzio, Dejan Krusec, Anouk Levels, Ana Sofia Melo, Katri Mikkonen and Petya Radulova[1]

Published as part of the Financial Stability Review May 2019.

This special feature discusses the channels through which climate change can affect financial stability and illustrates the exposure of euro area financial institutions to risks from climate change with the help of granular data. Notwithstanding currently limited data availability, the analysis shows that climate change-related risks have the potential to become systemic for the euro area, in particular if markets are not pricing the risks correctly. A deeper understanding of the relevance of climate change-related risks for the euro area financial system at large is therefore needed. Better data availability and comparability and the development of a forward-looking framework for risk assessments are important aspects of this work going forward.

1 Introduction

With evidence of rising global temperatures, awareness of climate change risks has been growing, leading to enhanced international action. The Intergovernmental Panel on Climate Change (IPCC) has estimated human activities to have led to around 1°C of global warming compared with pre-industrial times.[2] In most scenarios previously developed by the IPCC, without additional efforts to reduce carbon emissions, global warming is “more likely than not to exceed 4°C above pre-industrial levels by 2100”, although there is substantial uncertainty about the precise estimates.[3] Against this backdrop, the Paris Agreement, signed in December 2015, aims to limit the rise in global average temperatures to well below 2°C above pre-industrial levels and to pursue efforts to limit the rise to 1.5°C.[4]

Climate change may have significant impacts on the economy, both directly and indirectly through the actions taken to address it. Rising temperatures and changing patterns of precipitation would be expected to have direct impacts on agriculture and fisheries but they may also affect other sectors such as energy, tourism, construction and insurance.[5] While significant macroeconomic impacts from climate change may occur in the more distant future, some impacts are already beginning to be felt.[6] Policies implemented to try to prevent or moderate climate change (climate change mitigation) may also have wide-ranging sectoral impacts, potentially affecting the energy, transport, manufacturing and construction sectors in particular.[7] On the other hand, if the mitigating action is too timid, this will increase the magnitude and the pace of the necessary adjustment in the future, creating the potential for a sudden and general market correction or even an economic recession.[8]

While the need for financial sector adjustment as part of the climate challenge is widely acknowledged, key gaps remain in terms of measurement. Within Europe, discussions on the financial aspects of climate change have ranged from ongoing work at the European Commission to devise taxonomies that aim to support transparency and thereby market-based adjustment, to the establishment of a Network for Greening the Financial System (NGFS), where central banks and financial supervisors from five continents have joined forces to support the transition to a low-carbon economy and manage climate change risks. Foremost among the measurement gaps is the understanding of exposures of financial institutions to climate change-related risks. Partly, this relates to a dearth of sufficiently granular public data detailing complex and evolving exposures both within as well as across economic sectors. Notably, while country-level data can be used for tracking the implementation of political commitments, monitoring financial exposures to the global effects of climate change requires reliable and comparable data at the level of economic sectors or individual exposures. Limited empirical measurement has, in turn, constrained both market development and informed policy initiatives.

This special feature discusses general financial stability issues pertaining to climate change, examines potential financial exposures to it, and outlines policy considerations.[9] The first section briefly introduces the transmission channels of climate change risk to the financial sector. The second section explores the exposures of euro area financial institutions to climate risk-sensitive assets using sectoral and exposure-level data. The final section gives an overview of the ECB’s involvement in policy initiatives in the field of climate risk and financial stability and outlines priorities for further work.

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