12 Oct 2022

How climate change affects financial stability

In a SAFE-CEPR Policy Web Seminar, ECB experts set out the details of the current “Macroprudential Challenge of Climate Change” report

Climate change is one of the most pressing issues of our time. Not only does it affect our everyday lives, but also companies, investors, and policymakers have to take its consequences and costs into account. In a SAFE-CEPR Policy Web Seminar on 6 October 2022, Paul Hiebert, Stephan Fahr, Katarzyna Budnik, and Michael Grill, all economists at the European Central Bank (ECB), presented the ECB’s and European Systemic Risk Board’s report “The Macroprudential Challenge of Climate Change” from July 2022. By establishing a connection between visible outcomes of climate change, such as droughts, floods, and melting glaciers on the one hand, and implied effects on the social, political, and financial systems on the other, the report closely examines the substantial threat of lasting changes in the environment to financial stability.

Moderated by SAFE Director Jan Pieter Krahnen, Hiebert introduced the report and outlined that climate-related risks affect the entire financial system. The joint report provides insight into the impact of these risks on the European Union’s financial stability. “Our report links climate vulnerability to standard financial risk measurement and gauges implications for systemic risk,” Hiebert argued. He added that the report spans the cross-sectional and the time series dimensions of financial stability and thus could be integrated into macroprudential policy measures.

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Stephan Fahr explained the cross-sectional dimension of systemic risk in further detail: “To monitor and evaluate climate-related risks to financial stability, metrics that capture the nexus between climate and financial stability risks are needed”. As Fahr mentioned, non-financial borrowers are exposed to climate-related risk factors, which can harm their incomes, profits, and costs. However, financial institutions are exposed to these non-financial entities mainly through credit instruments and insurance liabilities. He added that natural hazards may cluster and generate self-reinforcing feedback mechanisms, as they may pose a risk to financial stability due to firms’ vulnerability to multiple hazards, for instance, heat stress and wildfires can exacerbate themselves and each other.

Katarzyna Budnik outlined the time series dimension of systemic risk. She presented the climate stress and scenario analysis and argued that generally, “climate risks are examined over long-term horizons, traditionally being used for stress testing and financial decision-making.” The authors focused on three long-term “Network for Greening the Financial System (NGFS)” scenarios: (1) the current policies are kept in place, (2) adapted climate policy is adapted immediately, and thus global net zero C02 emissions are achieved in 2050, and (3) delayed transition in climate policy until 2030 with possible additional costs on the economy in the short run.

Global cooperation is fundamental

Budnik added these scenarios did not have much of an impact on their models, . Hence, they introduced an alternative near-term scenario with a five-year horizon and emphasis on one risk at a time, for instance, a sharp increase in carbon prices, strong intensification of floods, and heatwaves to illustrate different aspects of climate adversity. By applying these scenarios to long-term scenarios (2) and (3) in comparison to current policies, the corporate probability of default will increase subtly in the short run but will be reduced substantially in the long run.

Following up, Michael Grill assessed the macroprudential policy response to the financial impact of climate change. According to Grill, a macroprudential approach to climate risks considers risks that are present across different sectors and can reduce cross-sector arbitrage. He added that “climate risks can affect financial stability through a regional concentration of physical hazards as well as the concentration of transition risks of high-emitting firms between and within economic sectors.” As stated in the report, macroprudential measures need to be consistent across borders and require close cooperation between global players, thus need to be seen in the context of a holistic prudential approach to climate risk.