Climate risk: the writing is on the wall

For the EU financial sector, climate risk is inescapable, but it could be tamed

From the Banque de France to the Deutsche Bundesbank and the Bank of England, most European central banks’ mandates include guaranteeing financial stability and resilience.

Over the past year and a half, policy-makers have reached a consensus in relation to climate change – one that will, at the very least, quantify its effects on the financial sector.

Judging by the first of what is likely become regular climate risk assessments, the threat to the banking sector alone is bigger than anything leveraged loans or shadow banking have ever posed.

For example, eurozone lenders will see the average probability of default (PD) by corporate borrowers rise, according to the European Central Bank, regardless of if and when net-zero policies are enacted. This is because of the increasingly frequent damage floods and wildfires will cause to those borrowers’ activities, particularly in the eurozone’s weakest members.

The only thing policies can still affect is by how much average PDs could rise – ie, whether banks can be spared the extra 15 basis points entailed by a scenario where governments fail to take any meaningful additional action on climate change.

Compounding the problem of rising chances of borrower default is that banks whose loan books are most exposed to so-called physical risk – as opposed to transition risk, the threat of rising costs and losses as the world moves away from fossil fuels – are also those more thinly capitalised. It’s the eurozone sovereign debt crisis redux, but with far less room for action.

Climate inaction could also derail a normalisation of interest rate policy that central banks have been seeking to kickstart for years. If governments don’t up their game against rising temperatures, a study by the Bank of England sees rate benchmarks collapsing in the short term, as central banks cut rates to enable businesses’ belated climate resilience push. By the time the 2040s come around, the benchmarks could still be languishing around the 1.5% mark, compared with 2.2–2.3% in scenarios where efforts to contain temperatures are successful.

The peril reaches well beyond bank lending, of course. Research focusing on funds and insurers has shown the value of everything, from equities to bonds, is at risk of a climate change haircut, with the utilities sector predictably among the most affected. When pension funds or university endowments divest from fossil fuel-linked stocks and bonds, they’re not only throwing their weight behind the climate transition – they may simply be shielding their portfolios from severe losses.

As more than one commentator has noted, society’s reaction to the Covid pandemic was arguably the closest thing we have yet to a climate change dry run. As for the financial sector, the next 30 years may be incomparable to anything it had to weather over the previous 30.