S&P Global Ratings welcomes the European Central Bank's upcoming climate risk stress test for banks as a way to push the sector into better management of climate risks. This exploratory exercise should reveal vast amounts of valuable insights into the potential risks for the sector and the preparedness of management teams to understand, manage, and mitigate them. S&P Global has identified the growth in prominence of climate stress testing in the financial services industry worldwide as a key trend that will drive the ESG agenda this year (see "S&P Global Outlines Key Trends That Will Drive The ESG Agenda In 2022," published on Jan. 31, 2022).

Despite some limitations, the ECB's stress test is further evidence of the EU authorities' resolve to address ESG risks. Such a proactive stance is a positive for rated banks in the jurisdictions. That said, we don't expect any immediate impact on the ratings for individual EU banks for the following reasons: the stress tests are exploratory in nature, with relatively mild assumptions, and the results will be anonymized. Currently, environmental factors have only a limited impact on our bank ratings because many public policies on climate have yet to take effect. Better and more comparable disclosures of banks' exposures and vulnerabilities to climate and environmental risks would benefit our credit analysis and help us further differentiate between banks.

Pushing banks to fully integrate climate risks

Together with the U.K.'s Prudential Regulatory Authority (PRA), the ECB is the second European supervisory authority to launch a "bottom-up" climate risk stress test in 2022. Contrary to previous economywide stress tests conducted by various regulatory authorities, the projections will not be made "top-down." Rather, the banks themselves will formulate the projections, using their own credit and market risk models under scenarios set by the ECB. This will require much more work from individual banks but bring more revealing results.

This stress test is part of a broader supervisory push to move climate risks higher on the risk management agenda for European banks and a wider regulatory push to include ESG risks into the three pillars of the Basel prudential framework (see box below). (For related reports on these topics, see "Climate Risk Vulnerability: Europe's Regulators Turn Up The Heat On Financial Institutions," published on Aug. 2, 2021, and "Basel Committee Proposal Highlights Banking Authorities' Focus On Climate-Change Risks," published on Nov. 17, 2021).

These initiatives are positive developments because most banks have not yet fully integrated climate risks into their risk management frameworks. In its recent assessment of the largest eurozone banks, the ECB noted that about one-half of them expect climate and environmental risks to have a material effect in the short to medium term, with the largest impacts to credit, operational, and business model risks. Despite that, only a few institutions have put in place climate risk practices in line with supervisory expectations. Integrating climate risks across the full spectrum of risk management activities will require major efforts for banks in the years to come.

It's more than just a stress test

The ECB's exercise has three modules comprising a number of qualitative and quantitative points (see chart 1). The overarching goal is to raise the bar for banks' internal stress-testing capabilities, by requiring them to collect data on their riskiest exposures and integrating climate risk dimensions into their regular stress test models.

Particularly interesting will be the comparison of the greenhouse gas (GHG) intensity reported by banks as part of the peer benchmark exercise (Module 2). Indeed, estimating banks' Scope 3 emissions (from clients in their financing portfolios) will be crucial to measure their overall carbon footprint and their progress toward net-zero emission goals. In practice, the GHG intensity metric developed by the ECB will measure the volume of GHG emissions emitted by the 15 largest counterparties in each of 22 most-impacted sectors, per €1 of revenue.

Under the three-year transition risk stress test, banks will forecast their potential credit and market losses under a base case and a disorderly transition. The ECB has based its assumptions on the scenarios provided by the Network for Greening the Financial System (NGFS). Under the disorderly transition, late and sudden policy actions to reverse climate change would lead to a tripling of carbon prices over a three-year period. However, the overall impact on macroeconomic variables would be relatively limited. For instance, the cumulative hit to GDP would be about 2%, compared with the baseline scenario. By way of comparison, last year's EBA stress test envisaged a far more substantial economic deterioration, with a cumulative GDP decline of about 13% over the three years between the adverse and the baseline case. Similarly, the assumed price shocks for key market variables, such as equity prices for most impacted sectors, are milder than those in last year's stress test. Given the positive results from last year's exercise and the less punitive assumptions set by the ECB, we expect that most banks will report only limited capital impact under the disorderly transition scenario.

In addition, banks will be asked to forecast potential credit losses in 2030, 2040, and 2050 for selected portfolios under three scenarios provided by the Network for Greening the Financial System (NGFS). Under each long-term scenario, banks will indicate how they would rebalance their exposures. This will be the most interesting part of this exercise, since predicting credit losses over such a long period of time is likely to be more art than science. Finally, banks will be requested to assess the effect on their credit portfolios of potential severe physical events--floods and heatwave/drought--affecting collateral values. For this part of the test, banks will be allowed to mitigate potential losses with existing private insurance covers as well as public natural disaster relief schemes. However, they will not need to account for second-round economic effects, such as potential losses on exposures to insurance companies. This will also greatly reduce the overall capital impact for most banks.

This stress test has many similarities with the U.K. PRA's Climate Biennial Exploratory Scenario (CBES), also to be conducted this year. In both cases, supervisors are using the long-term scenarios developed by the NGFS and seek to assess the business model transformations triggered by climate change, in addition to the potential credit losses. However, the two exercises differ in some respects. The PRA's CBES is broader since it covers major banks and insurance companies, but more limited in ambition because it only captures credit risks stemming from large corporate exposures. Last year, the Hong Kong Monetary Authority (HKMA) also conducted a bottom-up stress test requiring all major banks to forecast their credit losses under physical and transition risk scenarios. The results published in December showed that climate risks can give rise to significant adverse impacts on the banks' profitability, capital positions, and operations. Still, all in all, the Hong Kong banking sector would remain resilient to climate-related shocks given existing capital buffers.

Evidence of resolve to address ESG risks

A vast amount of data will be generated by the ECB stress test, a positive for the industry's understanding of this emerging risk. However, producing the data will represent a significant challenge for banks, given the lack of standardization in this area. For instance, the quality of the GHG intensity metrics will largely depend on banks' estimates of the Scope 3 of their main counterparties, which are not always disclosed. This means that banks will need to use proxies, leading to potential inconsistencies across banks. We expect recent regulatory initiatives to develop a standard disclosure framework for environmental risks to gradually improve availability and consistency of data.

Further, the tests will focus on selected risks and portfolios and therefore will not indicate the overall resilience of banks' balance sheets to climate risks. For instance, the long-term transition risk scenario will focus on credit portfolios within the bank's main country of operations, limiting the value of the exercise for the largest global systemically important banks or G-SIBs. Nevertheless, we view the exercise, as well as the other supervisory and regulatory initiatives taken in the EU, as evidence of the authorities' resolve to address ESG risks. Such a proactive stance is a positive for rated banks in the jurisdictions.

Both the ECB and the PRA announced that no additional capital requirements will be imposed on the back of these stress tests. Nevertheless, we assume that regulators will use the results to inform their day-to-day supervision, particularly where they identify outlying banks that are particularly unprepared or have poor risk management or data capabilities. We do not expect any significant market or rating impact, not least because the authorities will publish only aggregate results.

Better climate risk disclosure, better credit risk differentiation among banks

Currently, environmental factors only have a limited impact on our bank ratings. For most EU banks, our environmental credit indicator--measuring the influence of this factor on our rating analysis--is 2 (on a 1-5 scale, with 5 being 'very negative'). This indicates a neutral impact on our credit rating analysis. Better and more comparable disclosures of banks' exposures and vulnerabilities to climate and environmental risks would benefit our credit analysis and help us further differentiate among banks. Over time, the implementation of public climate policies will aim to reduce physical risks, but will in turn likely increase transition risks for economic sectors with elevated GHG emissions. At that point, banks' ability to measure and mitigate climate risks would become an important factor affecting their creditworthiness.

Editor: Rose Marie Burke. Digital Design: Joe Carrick-Varty.

Related Research

• S&P Global Outlines Key Trends That Will Drive The ESG Agenda In 2022, Jan. 31, 2022
• ESG In Credit Ratings Newsletter, Jan. 27, 2022
• Basel Committee Proposal Highlights Banking Authorities’ Focus On Climate-Change Risks, Nov. 17, 2021
• The Fear Of Greenwashing May Be Greater Than The Reality Across The Global Financial Markets, Aug. 23, 2021
• Climate Risk Vulnerability: Europe’s Regulators Turn Up The Heat On Financial Institutions, Aug. 2, 2021