On 8 July 2022, the ECB published the results of their 2022 Climate Stress Test (2022 CST), in which a total of 104 European banks participated. The stress test consisted of three modules. While Module 1 started with a qualitative assessment of the status quo of banks' internal stress testing capabilities, Module 2 focused on banks' income sensitivity in relation to their exposure to carbon-emitting industries, and Module 3 examined banks' vulnerability to transition, physical and operational risks under three scenarios. Overall, the results of the 2022 CST highlight the current data and methodological limitations of such exercises, but also provide important insights into the extent to which banks are prepared to integrate climate risks into their risk management processes and business strategy.
Out of the 104 European banks assessed in the first two modules, only 41 banks participated in the more thorough bottom-up stress test in the third module. In assessing the banks' internal stress testing capabilities using a qualitative questionnaire, the ECB found that about 60% of banks do not conduct internal climate stress testing at all. Around 80% of the banks that already have an internal climate stress testing framework do not incorporate it into their lending process. 17 out of the 43 banks that already have an internal climate stress testing framework do not involve internal audit in the review of their framework, and about 32 banks do not ensure independence between the framework validation and development processes. As a result, the ECB issued the lowest score to 21% of banks for internal audit and to 49% for governance and risk appetite.
With regard to banks' exposure to carbon-emitting industries, the ECB found that, on average, banks earn more than 60% of their interest income from the 22 highest-carbon intensive industries, including mining, construction, and real estate, making them particularly prone to transition risks. In addition, the ECB found a high dependency on income from carbon emitting sectors depending on the type, scale, and complexity of banks, with development banks, small domestic credit institutions, and retail lenders particularly affected. Global systemically important banks (G-SIBs) tend to be in the middle range of affected institutions.
For the 41 banks that participated in the more thorough bottom-up stress test, the ECB found cumulative credit and market risk losses of EUR 70 billion under the three-year short-term transition and the two physical risk scenarios. The ECB did not provide a loss projection for the long-term transition risk assessment but concluded that an orderly transition causes fewer loan and overall losses than a disorderly or no transition. In assessing physical risks, the ECB noted that banks' vulnerability depends to a large extent on the geographical location of their exposures. Sectoral activity played an important role in the assessment of heatwave and drought risk, with outdoor sectors such as agricultural activities, construction or mining particularly affected. Although the stress test stated that bank losses are lower under an orderly transition scenario than under a delayed approach, the ECB did not provide detailed figures. This drew some criticism among observers after the results were published.
In particular, the assumption of a three-year short-term transition scenario for the total loss projection is too short to capture the full impact, given the nature of the risks associated with climate change. Further criticism of the climate stress test stems from the fact that it neglects related macroeconomic aspects, such as economic downturns and second-round effects, and considers only the total exposure of about one-third of banks, as the focus of the exercises was only on vulnerable sectors. Consequently, the results may represent a significant understatement of actual risks, which the ECB has acknowledged. Future ECB climate stress tests may introduce more sophisticated models and scenarios in order to arrive at a more realistic risk assessment.
CST challenges for banks
The ECB observed that banks faced several challenges during the 2022 CST and in integrating climate risks into their internal stress tests. These fall into three main categories:
Risk management and governance: A major challenge that banks faced was integrating climate risk into the internal capital adequacy assessment process (ICAAP), particularly in terms of determining risk appetite, overall integration into risk management, and strategy integration. Only 26 banks used the results of the climate stress tests in their business strategy and only 8 in their lending process. Another challenge was establishing quality assurance processes for the internal stress testing framework and integrating the results into the governance framework.
Modeling climate risk: One of the major challenges banks faced in modeling climate risks was the long-time horizon of transition risks, which often exceeds the time horizons of traditional financial risk models by far. Other challenges included anticipating customer behavior, which acts as the main trigger for transition risks, and integrating and modeling physical risk drivers, such as extreme weather events.
Data availability: The availability of data was another major challenge faced by banks during the stress test and when integrating climate risks into their internal stress testing frameworks. Typical examples of missing or inconsistently available data types include data on counterparty climate strategies and targets, granular location data, GHG emissions and EPC (Energy Performance Certificate) rating data, which are essential for conducting climate stress tests. In particular, with respect to Scope 3 emissions, which far outweigh Scope 1 and 2 emissions in most of the 22 carbon-intensive sectors, the ECB noted a wide dispersion of reported data.
The ECB describes the 2022 Climate Stress Test as essentially a learning exercise, exploratory in nature. Hence it does not come as too much of a surprise that the actual climate risks are not comprehensively and adequately assessed, given that the ECB did not use adverse scenarios and banks had limited stress testing capabilities, particularly in terms of data.
Outside of the bottom-up stress test, the ECB found that many banks do not incorporate climate risks into their internal stress tests. And even among those banks that do have internal climate stress tests, the ECB sees room for improvement in several areas, such as the quality of the underlying models or their integration into risk management and corporate governance. The critical importance of this is underscored by the fact that European banks are still highly dependent on carbon-emitting industries. Banks may therefore need to adjust their portfolios, for example by creating transition incentives for their clients.
The results of the 2022 CST will not have a direct impact on banks' capital requirements and will only feed into the annual Supervisory Review and Evaluation Process (SREP) assessment in a qualitative and indirect way, where climate risks are not assessed individually but in conjunction with other risk drivers. In their assessed state, no bank carried out climate stress testing in a perfect way. To support banks, the ECB sends each participating bank individual feedback and is expected to release a set of good practices by the end of 2022. For the coming years, the ECB has expressed a clear expectation that "all institutions under its direct supervision will improve their stress testing capabilities" The ECB is going to closely monitor those improvements and is expected to run a new CST in 2023.
The CST should be seen in the broader context of activities that ECB Banking Supervision will be undertaking this year, such as the 2022 thematic review of the integration of climate and environmental risks into banks' strategy, governance, and risk management frameworks and processes
ESG and especially the integration of E, S and G risk factors into existing risk management frameworks, including climate stress testing, is uncharted territory for the financial services industry. Capco has a strong and rich track record of supporting clients with their change processes, spanning a wide range of system and process implementations. We have developed a unique integration approach to climate risk that includes integrating climate risk into risk management processes and creating a robust data framework. Contact us to learn more about how we can help your institution on its journey to change and give you an edge over your competition.