Climate action to have ‘limited impact’ on financial system, EU finds

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European regulators found there would be only a “limited impact” on the financial system from the EU’s drive to cut carbon emissions by 55 per cent by 2030, even if it caused investors to ditch polluting companies.

The EU’s top financial watchdogs on Tuesday said their first stress test to estimate how the fight against climate change would affect banks, insurers, pension funds and investors concluded it “would not be a concern for financial stability per se during the green transition”.

Over the eight-year horizon of the test, the impact of the EU smoothly achieving its Fit for 55 plan to more than halve emissions over the next six years would result in initial first-round losses for the financial system equal to 3.9 per cent of starting-point exposures.

This would rise to 6 per cent if there was a sudden correction in asset prices — a run on so-called brown assets — and to 8.7 per cent if it included second-order spillover effects, where investors responded to the change in conditions by, for example, rebalancing their portfolios.

But if these effects were compounded by an extra macroeconomic shock similar to the one modelled in the regulator’s annual banking stress tests, it could lead to total losses of 20.7 per cent in the financial system.

The regulators warned that “adverse macroeconomic developments could disrupt the evolving transition and substantially increase financial institutions’ losses, thereby impairing their financing capacity”.

The results were published as negotiations to tackle climate change and transition away from fossil fuels continued at the UN COP29 summit in Baku this week amid fears that Donald Trump’s US election victory could put the brakes on the green movement.

EU regulators said the outcome of their stress test “calls for a co-ordinated policy approach to financing the green transition and the need for financial institutions to integrate climate risks into their risk management in a comprehensive and timely manner”.

The stress test assumed financial groups kept a “static balance sheet” with little ability to take mitigating actions. Regulators said it was likely to have overestimated losses because it did not consider the benefit of rising income, such as from higher interest rates or changes to insurers’ liabilities.

They also only considered the benefit of hedging for banks and not for other financial groups and did not take into account the share of losses that would be absorbed by policyholders.

The exercise examined the impact on 110 banks, 2,331 insurers, 629 pension funds and about 22,000 EU-domiciled investment funds. It was carried out by the European Central Bank, as well as the three main EU regulators for banking, markets and insurance and pensions.

“The purpose of this exercise is not to set micro- or macroprudential requirements for financial institutions,” they said. “The results will inform the work of the European Commission, the ESAs and the ECB.”

The EU’s Fit-for-55 package aims to reduce emissions by 55 per cent by 2030 compared with 1990 levels, including an emissions trading system, a carbon border adjustment mechanism and sector-specific targets.