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Stress tests promise greater clarity around European banks' climate risk

For investors concerned about climate-related exposure at European banks, a new way of assessing risk is on the horizon.

Regulators in Europe are fine-tuning their approach to climate stress tests, which can provide key data on exposure to so-called stranded assets and help with risk assessment amid concern about the economic impact of climate change, according to bankers and analysts.

Global energy sector assets lost $1.4 trillion in value between 1997 and 2017, according to estimates by credit insurer Euler Hermes. A further $300 billion to $1.6 trillion may be lost in the future from "stranded" energy assets that may be rendered obsolete by a transition to a more sustainable economy.

In a 2018 climate stress test, the Dutch central bank predicted that a climate shock could knock 3% off the value of banks' assets and damage capital ratios.

'Levers of change'

Since the global financial crisis, stress tests have become a critical tool for regulators to gauge how well banks can withstand hypothetical adverse scenarios, and the coronavirus crisis may spur the development of climate-specific testing.

"You can see the impact of an abrupt transition taking place now so the motivation for preparing for a much more gradual and more managed transition should be there," said Nina Seega, research director for sustainable finance at the University of Cambridge's Institute for Sustainability Leadership, who worked with the Dutch central bank on its climate stress test.

Stress tests are one of the biggest tools in the arsenal of central banks for assessing how banks can withstand economic shocks, she said.

France's financial regulator, the Autorité de Contrôle Prudentiel et de Résolution, or ACPR, will publish the results of its first climate stress test in April 2021, while the European Banking Authority will also develop a climate stress test. The Bank of England is working on a climate stress testing process although it has postponed its stress tests due to the pandemic.

SNL ImageClimate change protesters gather outside the Bank of England in the City of London on April 25, 2019.
Source: AP Photo

Leila Kamdem-Fotso, a partner in financial services at consultants Mazars, who has authored a report on central banks and climate change, said the BoE's delay may be beneficial because the initial calendar was "extremely ambitious." The timing is probably "more realistic" now, which may be positive for the results, she said.

U.K. banks have made "considerable progress" in climate risk management and collecting data because of the test's wide-ranging nature, she said.

For Barclays PLC, scenario analysis and stress testing "get the big levers of change inside a bank cranking around those issues," said Elsa Palanza, global head of sustainability and citizenship at the U.K. bank. Various internal teams come together and it "embeds those principles into the very fabric of the bank," making climate change no longer just an issue for the sustainability team, she said.

Seega, who is also an academic visitor at the BoE, said she welcomed the U.K. central bank's approach of testing both banks and insurers. Banks are assuming they can rely on insurers to pay for climate-related losses, but insurers are assuming they can pull out of some coverage or change pricing because of climate risks, she said.

"There is value in a financial regulator running the test on both industries because it will bring to light the contradictions in those assumptions," she said.

Longer-term view

The BoE's tests will be mandatory, while in France, the ACPR's stress tests will be voluntary, but Laurent Clerc, the ACPR's director for research and risk analysis, told journalists France's major banks and insurers, which include BNP Paribas SA and Société Générale SA, would take part.

Clerc said the ACPR would test 80% to 85% of banks' exposure, focusing on credit, market and counterparty risk.

The ACPR's stress test will encourage financial institutions to think beyond a three-to-five year horizon and assess the resilience of their business models over the next 30 years, Kamdem-Fotso said, although she warned that there were limited tools and data to use.

Kamdem-Fotso said the ACPR's approach of looking at the combination of "static" balance sheets from 2020 to 2025 and then "dynamic" ones from 2025 until 2050 was more plausible than the BoE's long-term static approach. But, she said, it will probably be more challenging to aggregate and analyze the results of all institutions. A static approach assumes the size, composition and risk profile of a bank's balance sheet remains the same over the time period in question.

Laurence Pessez, head of corporate social responsibility at French bank BNP Paribas SA, said she expected stress tests to be a "step by step" process during which both banks and regulators learn about the best methodologies and data to use.

While the French tests will not be mandatory, she said that could change in the future, which could push banks' customers to better assess their risk.

"We'll have a real lever to put pressure on our clients," she said.

'Concrete tool'

Differences in stress testing methods between regulators raise challenges for cross-border banks and make it difficult for central banks to compare results, but that should be resolved over time because of the EBA's climate plan, which will require banks to include environmental, social and governance factors in their risk management policies, Kamdem-Fotso said.

SNL Image

A windmill and wind turbines in Zoeterwoude, the Netherlands.
Source: AP Photo

Cooperation between central banks through the recently formed Network for Greening the Financial System — a global network of regulators collaborating on climate change — will also help. The network published a guide in June to help central banks analyze climate risk.

This is a "concrete tool" that simplifies calculations around the impact of climate change and will help with the development of climate scenario analyses, according to Morgan Després, the head of the NGFS secretariat and deputy head of financial stability at the Bank of France.

Regulators may also take inspiration from the Dutch central bank's climate stress test. It considered government policy and technological developments as well as a drop in consumer and investor confidence, and examined the corporate loan exposures, and equity and bond exposures, of the largest Dutch banks — ABN AMRO Bank NV, ING Groep NV and Rabobank. It also examined insurers' and pension funds' exposures.

It estimated that, if the carbon price rose to $100 and the share of renewable energy in the energy mix doubled, the value of banks' assets could decline by up to 3%, and their capital ratios by up to 4 percentage points. The carbon price is a cost applied to carbon pollution. Benchmark December 2020 carbon futures were trading at €27.62 on the ICE exchange July 1.

The Dutch model will be rolled out more broadly by other regulators, and the tests will show where climate risks and fossil fuel exposure are sitting in the system and which banks are better prepared to deal with them, according to Zacharias Sautner, professor of finance at the Frankfurt School of Finance and Management.