A new research has revealed that climate risks can spread rapidly and harm companies, banks and other financial institutions alike.
The joint research report by the European Central Bank and the European Systemic Risk Board provides evidence on the systemic nature of climate risks and provides a foundation for a macroprudential policy response.
It identifies several amplifiers of climate risk across the financial system. Transition risks may be magnified because of economic and financial linkages between and across banks and companies.
The report said interdependent natural hazards – such as water stress, heat stress and wildfires – can amplify physical climate risk, as they can cluster together and exacerbate each other. Market dynamics can also magnify the financial impact of physical risks. For example, a climate shock could lead to a sudden reassessment of climate risk pricing, thereby causing fire sales, where financial institutions – especially those with overlapping portfolios – quickly sell a large number of exposed assets at the same time at distressed prices.
Scenario analysis suggests that climate risks might take shape in the financial system in a specific order. First, unforeseen climate shocks could have an abrupt impact on market prices, initially hitting the portfolios of investment funds, pension funds and insurance companies.
Second, this sudden repricing could cause companies to default, resulting in losses for exposed banks. In a disorderly transition scenario, marked by an immediate and substantial increase in carbon prices, respective market losses of insurers and investment funds could potentially amount to 3% and 25% on stress-tested assets in the near term.
An orderly transition towards net zero by 2050 could soften such shocks and alleviate the fallout for companies and banks, reducing the probability of corporate defaults by around 13-20% in 2050 compared with today’s policies. It would also lessen credit losses for banks.