2023 is off to a crucial start for the European Union’s sustainable finance agenda. Members of the European Parliament are about to vote on the extent to which European banks and insurers should consider climate change as a material risk for their activities. In this debate, a central element is identifying whether investing in environmentally harmful sectors entails high risks for financial stability.
Climate risks and the stability of the financial system
Climate risks will cause financial instability and irrecuperable socioeconomic damage if no action is taken soon, according to forecasts. Financing high-risk activities will cause long term economic harm, as these investments’ profitability is bound to quickly decline in a world transitioning to climate neutrality.
From an environmental perspective, the Intergovernmental Panel on Climate Change (IPCC) already argued that reaching net zero by 2050 implies an end to financing new fossil fuel projects. Estimates on socioeconomic losses caused by bailing out the impact of these risks on the financial sector within the EU go up to €1.8 trillion by 2030.
Mitigating climate-related risks
There are ways to start mitigating these risks now. In their upcoming votes on the EU banking and insurance regulations, Members of the European Parliament must enshrine in law ambitious requirements to ensure these risks are captured by the financial sector:
- Increase the amounts of money financial institutions need to hold aside (“capital requirements”) when financing high-risk activities. For example, the “One-for-One” civil society campaign advocates one dollar put in these high-risk investments should result in one dollar set aside in capital requirements for financial institutions.
- Require mandatory transition plans for financial institutions. As key actors in the financing of the economy, financial institutions should detail their trajectory towards achieving a net zero transition and phasing out high-risk, environmentally harmful investments. These plans should not interfere with EU corporate disclosure regulations and must build upon the recommendations of European and international sustainability standard setters.
Despite significant progress in climate disclosures and a number of voluntary pledges to phase out fossil fuel investments, the financial sector does not yet assess climate risks to a sufficient extent. For example, the European Central Bank (ECB) revealed significant gaps in the evaluation of the potential impacts of climate risks by the largest EU banks and imposed a 2024 deadline for meeting its supervisory expectations.
This is partly due to uncertainties on the precise impact of climate change to the financial system. Companies’ sustainability data is still lacking, and current financial models and scenarios struggle to grasp the forward-looking, long-term, non-linear impacts of climate change. This is even more the case when we go beyond climate and consider biodiversity loss, or the potentially systemic impacts and diffusion of climate-related risks across the entire financial system.
Why uncertainty should not stand in the way of climate risk mitigation
However, uncertainty should not lead to inaction. The European Parliament will vote on the EU banking regulation on 24 January. The vote on the EU insurance regulation is expected to follow a few weeks later.
These votes will be a first concrete step for the EU towards active acknowledgment of climate-related financial risks and a start to phasing out investments in high-risk activities. Domestically, the EU should use this opportunity to start incorporating a credible holistic framework for transition finance – the first steps for which were proposed by E3G. This could be the initial building block for an ambitious next phase of the EU sustainable finance agenda.
Having the European Parliament move in this direction is not only a way to address current risks for the EU financial system, but can also be a crucial contribution to the international direction of travel . Indeed, international authorities, such as the G20-mandated Financial Stability Board and the Basel Committee have started their ongoing assessment of these issues.
This would be a way for the EU and its member states to strengthen international cooperation on building a resilient financial system fit for climate challenges, including as part of global workstreams such as the Bridgetown initiative.