2022 ECB climate risk stress test: A journey starts with a single step

The ECB published the aggregate results of its climate risk stress test on 8 July 2022, two days after sending individual letters with bank-specific findings. Although banks have made significant progress with their climate stress testing capabilities, the exercise revealed deficiencies, data gaps and inconsistencies across institutions. Given the exploratory nature of the exercise, the outcomes will have no direct capital implications for participating banks and supervisory findings will only feed into this year’s SREP from a qualitative perspective. The ECB is expected to conduct follow-up activities with banks in the second half of 2022 by giving bank-specific recommendations and providing further guidance to overcome the current challenges.

The 2022 ECB climate risk stress test exercise was considered a learning exercise for both banks and supervisors. The ECB assessed significant institutions’ climate risk stress testing capabilities and the degree of preparedness of EU banks for managing climate risks in comparison to their peers by reviewing both qualitative and quantitative elements. The set of elements reviewed during the exercise included governance-related aspects, climate-related data availability, adequacy of direct and indirect transmission channels such as carbon price shocks, scenario development capacity, the concentration of sectoral interest and fees income, financed GHG emissions, banks’ plans for financing the green transition and stress test projections, among others.

The methodology of the exercise was built upon the following three modules.

Source: ECB, 2022

It is important to note that the climate risk stress test is part of a wider climate roadmap, complementing the ongoing supervisory thematic review of banks’ climate-related and environmental risk management practices following the expectations laid out in the ECB guide.

Based on the outcomes of the CST, the ECB is expected to provide further guidance to banks during the second half of 2022 with specific recommendations and best practices for enhancing their climate risk stress testing frameworks and overcoming the current challenges.

What is clear is that climate-related and environmental risks will remain high on the agenda as a priority for the years ahead and banks should expect on-site missions and deep-dives.

As highlighted by the ECB, although banks have made substantial progress concerning their climate risk stress-testing capabilities, the results of the exercise have revealed deficiencies, data gaps and inconsistencies across institutions. Thus, banks are expected to make further progress in the following years both in terms of data and methodologies to properly identify vulnerabilities and build resilience against the materialisation of climate-related risks to comply with future regulatory requirements.

The main findings and recommendations resulting from the 2022 ECB climate risk stress test exercise are as follow:

• Climate risk stress testing framework: Banks seem to be in a very early stage in the development and implementation of climate-risk stress testing frameworks. Around 60% of participating banks do not have yet a well-integrated framework and the key driver is the lack of reliable climate-related data. Furthermore, most of those banks foresee a medium to long-term timeframe (at least 1 to 3 years) for including physical and/or transition climate risks into their frameworks. Lastly, among all the components/ blocks assessed as part of the module 1 questionnaire, Governance and risk appetite received the worst scoring (74% of banks received either score equal to 3 or 4).
• Climate-relevant data: Most banks used approximation techniques and/or data from external providers to overcome data gaps on GHG emissions and Energy Performance Certificates (EPCs). In particular, 65% of the banks used predominantly proxies to allocate exposure to EPC ratings. Moreover, banks seem to depend to a great extent on estimates using proxies for GHG emission data for large parts of credit portfolios. Especially for scope 3 emission data, due to the complexity underlying the gathering of relevant data on associated emissions. While future regulatory requirements including EU disclosure rules could increase data availability to replace proxies (currently only large and capital markets-oriented corporates are in scope of the Corporate Sustainability Reporting Directive), banks are advised to conduct further work to improve their data infrastructure and data collection of climate-relevant breakdowns, e.g., by enhancing customer engagement to collect relevant counterparty information.
• Banks’ exposure to climate risks: On average, more than 60% of the non-financial corporate interest income of participating banks stems from businesses belonging to the 22 most GHG-emitting sectors, however with different results across business models i.e., “Development banks/promotional lenders” and “small domestic banks” were more reliant on incomes from those sectors, compared to “Custodians and asset managers” or “Global Systemically Important Banks”. However, it is key for banks to engage with clients to gain insights into their transition plans to size their exposure to climate risk in the future.
• Climate-related credit risk modelling capabilities: Although banks have put efforts into the preparation of the projections, it seems they are still in an early stage in terms of factoring climate risks into their internal credit risk stress-testing models. Moreover, Credit risk parameters seem fairly insensitive to the climate shocks included in the scenarios. Against this background, banks will need to enhance their modelling capabilities. Some good practices identified by the ECB during the exercise include i) the incorporation of the sectoral dimension into banks’ models to reflect the differences in the projected sectoral risk parameters in accordance with the asymmetric shocks across industry sectors; 2) the inclusion of both direct and indirect transmission channels (e.g., carbon price shocks, GHG emissions pathways and macroeconomic variables) by increasing the understanding of sector-specific transmission channels and critical assumptions made for the transition; 3) the performance of analysis at counterparty level, with actual data and good approximation techniques.

Even though the upcoming EU-wide stress testing exercise is already in the spotlight, the results of the 2022 ECB climate risk stress test signal to banks the real need to step up efforts to enhance their climate risk stress testing capabilities to be future-proof in the eyes of supervisors and regulators. However, it is clear this is a topic that is going to remain high on the agenda of the ECB next year; the EBA also intends to build the fundamentals for a robust climate risk stress test framework in line with the new mandates awarded by the European Commission, as indicated in the 2021 EBA’s annual report. Although the results of the exercise will only be factored into this year’s SREP from a qualitative perspective, banks should consider how they plan to approach increased supervisory pressure and expectations in the space of climate-related and environmental risks in the years ahead.

Our key propositions include:

• Building on the results, scenarios, and processes of the 2022 CST exercise to embed climate risk into day-to-day risk management frameworks, including the capital planning process (e.g., ICAAP)
• Enhancing data availability with climate-relevant counterparty-level data breakdowns and developing solid approximation techniques
• Improving climate risk stress testing methodologies and modelling capabilities
• Developing credible transition strategies and assessing client transition plans