23 January 2024
The misalignment with the EU climate transition pathway can lead to material financial, legal and reputational risks for banks. It is therefore crucial for banks to identify, measure and − most importantly − manage transition risks, just as they do for any other material risk writes Frank Elderson, member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB.
Eight years ago in Paris, global leaders reached a landmark agreement, committing to limit the global temperature increase to below the calamitous threshold of two degrees Celsius. Alarmingly, the latest scientific evidence[1] indicates that we are currently on a global heating path of 3°C.[2] Through the risk-based lens of a banking supervisor, this is seriously concerning – the longer we wait to transform our economy, the more disruptive the transition and the greater the risks that will materialise on banks’ balance sheets.[3] It is therefore crucial for banks to identify, measure and − most importantly − manage transition risks, just as they do for any other material risk.
How transition risks affect banks
In the European Union, the Paris Agreement has been transposed into the binding European Climate Law, which requires carbon neutrality by 2050. The commitment to reduce emissions by 55% by 2030 is further reinforced by the EU’s “Fit for 55” strategy. As the economy transitions towards meeting these goals, industries need to adjust how they operate. And since most companies in the EU with high-emitting production facilities rely on bank financing, this also has a significant impact on banks’ balance sheets. For instance, various studies suggest that phasing out fossil fuels to meet the Paris Agreement may very well leave about 80% of fossil fuel assets stranded in the absence of a timely transition[4], which will lead to financial losses for banks that are exposed to companies with those assets. Think about higher CO2 prices for high-emitting steel and cement producers under the reformed EU Emissions Trading System, or the ban on the sale of new petrol and diesel cars from 2035. Companies that do not adjust to these policies and fail to reduce their carbon footprint in a timely manner will face higher risks over time. Hence, misalignment with the EU transition pathway can lead to material financial, legal and reputational risks for banks[5].
To be clear: it is not for us supervisors to tell banks who they should or should not lend to. However, we will continue insisting that banks actively manage the risks as the economy decarbonises. And banks cannot do this without being able to accurately identify transition risks and how they evolve over time.
So how, exactly, can banks do that?
Quantifying transition risks is crucial
The first step is acknowledging the materiality of the risks. Over 80% of euro area banks have already concluded that transition risks have a material impact on their strategies and risk profiles. As a second step, it is crucial to measure transition risks in a forward-looking manner. This is, admittedly, the Achilles’ heel of the exercise considering the relatively carbon-intensive starting point of most economies and the continuous evolution of emission reduction policies. But while quantifying the risks is challenging, it is far from impossible.
To demonstrate how this quantification can be done, today the ECB is publishing a report on “Risks from misalignment of banks’ financing with the EU climate objectives”, where we quantify the most pronounced transition risks in the credit portfolio of the banking sector. We do this through “alignment assessment”, a methodology that is already being developed by banks and regulatory and supervisory authorities. It measures transition risks by comparing the projected production volumes in key economic sectors with the required rate of change to meet given climate objectives. It is a forward-looking assessment that covers a five-year horizon by considering the carbon impact of the production plans of companies in those key sectors. The assessment can be repeated over time, making it possible to measure whether a company is transitioning towards low-carbon production and to what degree the pace of transition is consistent with EU climate policies. The methodology currently includes economic sectors with the most pronounced transition risks that account for 70% of global CO2 emissions.
Key findings from the ECB’s quantification of transition risks
Our analysis of 95 banks covering 75% of euro area loans shows that currently banks’ credit portfolios are substantially misaligned with the goals of the Paris Agreement, leading to elevated transition risks for roughly 90% of these banks. The analysis shows that transition risks largely stem from exposures to companies in the energy sector that are lagging behind in phasing out high-carbon production processes and are late in rolling out renewable energy production.
Additionally, 70% of these banks could face elevated litigation risks as they are publicly committed to the Paris Agreement, but their credit portfolio is still measurably misaligned with it[6].It is therefore vital that these banks do more work with their counterparties to ensure the companies they finance do not prevent them from living up to their net-zero commitment. This is more relevant than ever, considering that climate litigation has skyrocketed in recent years. Globally, some 560 new cases have been filed since 2021 and increasingly also targeted at corporates and banks.[7]
Transition planning – the foundation of a transition pathway
Banks are thus significantly exposed to transition risks and generate over 60% of their interest income from counterparties in carbon-intensive sectors.[8] The best thing banks can do is putting in place Paris-aligned transition plans. By this, I mean realistic, transparent, and credible transition plans that banks can and actually do implement in a timely manner. They should include concrete intermediate milestones from now until 2050 and develop key performance indicators that allow their management bodies to monitor and act upon any risks arising from possible misalignment with their transition path.
Banks can leverage on the alignment assessment methodology outlined in our report to advance their transition planning capabilities. Exchanging good practice among regulators, supervisors and the banking industry is essential in mastering the mammoth task of making banks transition risk proof. That is why we published the good practices that we observed in both the climate stress test[9] and the thematic review[10]. For instance, some frontrunner banks have already started to use transition planning tools, including alignment assessment, to measure risks in their credit portfolio stemming from the transition towards a decarbonised economy. Other banks have already started managing transition risks through active client engagement, and by offering transition finance products. These encouraging examples show that while it may be challenging, it is far from impossible.
Transition planning must become a cornerstone of standard risk management, as it is only a matter of time before transition plans become mandatory. In fact, the revised Capital Requirements Directive (CRD VI) includes a new legal requirement for banks to prepare prudential plans to address climate-related and environmental (C&E) risks arising from the process of adjustment towards climate neutrality by 2050. The latest revisions to the Capital Requirements Directive (CRD VI) mandate supervisors to check these plans and assess banks’ progress in addressing their C&E risks. Supervisors are also empowered to require banks to reduce their exposure to these risks and to reinforce targets, measures and actions included in their plans.
Moreover, banks that fall within the scope of European Banking Authority’s Implementing Technical Standards on Pillar 3 disclosures on environmental, social and governance risks will have to disclose the Paris alignment of their credit portfolios by the end of 2024 at the latest. Banks can therefore make use of the methodology set out in our report to meet this disclosure requirement.
Conclusion
The economy needs stable banks particularly as it goes through the green transition. It is in turn crucial for banks to identify and measure the risks arising from the transition towards a decarbonised economy. As ECB Banking Supervision we will continue to play our role in spurring banks to manage the inevitable risks materialising from the transition, just as they would for any other risk. This will ensure the banking system remains resilient and sound in our net‑zero future.
