Is the European financial system ready for climate risks?

Floods in The Brown Cow, Bingley, Bradford, United Kingdom
Floods in The Brown Cow, Bingley, Bradford, United Kingdom. Photo by Chris Gallagher on Unsplash.

European institutions and authorities are starting to pave the way for the next challenge in the EU’s sustainable finance policy: the identification and integration of climate-related risks by EU financial institutions. This challenge is difficult to face mainly due to the lack of relevant data and adapted financial methodologies. Progress from European and international workstreams in these areas is concrete, but slow. Therefore, the EU should quickly lay down regulatory initiatives incentivising financial actors to effectively mitigate the effects of climate risks on their activities.

Climate risks can also be understood as financial risks posed by the exposure of financial institutions to climate change. These can be physical risks, such as extreme weather events. They can also be transition risks, when caused by adjustment towards a lower-carbon economy. In the EU, physical climate risks alone are estimated to have caused financial losses exceeding €487 billion over the last 40 years.

Despite these stark numbers, the EU’s financial industry has not yet designed efficient and systematic ways to incorporate these risks in its internal governance practices. For example, only 60% of the largest EU banks under European Central Bank (ECB) supervision have internal frameworks considering climate risks. Only 20% consider climate risks when granting loans. These banks also lack robust, long-term strategies to tackle climate risks.

How to explain these poor results?

There is a significant gap between the nature of climate risks and the risk management methodologies and data currently used by financial actors and supervisors. The EU’s financial regulatory framework is based on risk assessment methodologies that rely on historical data, backwards-looking models and predictions over a 1–3-year period. This framework is not designed to incorporate climate risks, which are inherently forward-looking, long-term, non-linear and irreversible. In addition, using existing scientific climate risk data in financial terms remains expensive and difficult.

Positive shifts are happening, however. The European Systemic Risk Board (ESRB) and ECB recently noted progress in tackling the longer-term horizon, models, and dynamic nature of climate risks. European authorities regularly publish guidance on climate risk-related supervisory practices or information disclosure, with EU and international sustainability reporting standards currently in the making. Particularly promising on this front is the work by international supervisors’ networks such as the Network for Greening the Financial System (NGFS) to develop common climate risks scenarios. So is the sharing of best supervisory practices by the Financial Stability Board (FSB) or Basel Committee on Banking Supervision (BCBS).

What can the EU do in the short term?

Positive developments to identify and evaluate climate risks are underway both at the European and international levels. However, these efforts take time to materialise into usable financial risk models and methodologies, whereas climate impacts are already affecting our economies. Therefore, the EU must take immediate steps to integrate these risks into its financial framework and mitigate their effects as soon as possible.

First, EU legislators should use regulatory incentives to effectively integrate climate risks into the risk management processes of financial institutions.

  1. The current reviews of the EU banking and insurance regulatory frameworks should explicitly require these actors to assess climate risks that could impact their activities.
  2. Financial institutions should draft mandatory transition plans setting clear time-bound targets at short, medium, and long term, to assess their commitment to managing their climate risks.
  3. Moreover, regulators should reevaluate the financial risks associated with assets linked to, for instance, fossil fuel exploitation, which will lose value due to climate change and could become ‘stranded’.

Second, these targeted measures should be completed by a clear EU systemic strategy to tackle climate risks, as suggested by the ESRB. This should cover banks, insurance companies and asset management companies. Most importantly, this strategy should focus on identifying the interconnections between these sectors.