Transition risk losses alone unlikely to threaten EU financial stability

The European Supervisory Authorities (EBA, EIOPA, and ESMA – the ESAs), in collaboration with the European Central Bank (ECB), today unveiled the results of the one-off “Fit-For-55” climate scenario analysis, revealing that while transition risks alone are unlikely to destabilise the financial system, the combination of transition risks and macroeconomic shocks could significantly increase losses for financial institutions.

This conclusion highlights the necessity for a coordinated policy approach to the green transition and the integration of climate risks into financial institutions’ risk management practices.

The assessment, initiated at the request of the European Commission, focused on the impact of three distinct transition scenarios tied to the EU’s Fit-for-55 package on the banking, investment fund, occupational pension fund, and insurance sectors. The Fit-for-55 package aims to stimulate investment and innovation in the transition to a green economy and plays a crucial role in the EU’s goal to achieve an emissions’ reduction of 55% by 2030 and climate neutrality by 2050.

It aims to bring EU legislation in line with these goals with a set of policies that include – among others – the EU emissions trading system, the carbon border adjustment mechanism, sector-specific emissions targets, as well as revisions to the renewable energy and energy efficiency directive.

Scenarios and methodology

The climate stress test, designed by the European Systemic Risk Board (ESRB) with ECB support, examined three scenarios which incorporate transition risk as well as macroeconomic factors, under the assumption that the Fit-for-55 package is implemented as planned:

1. Baseline scenario: Reflects the implementation of the Fit-for-55 package under economic conditions consistent with the European System of Central Banks’ June 2023 forecasts, incorporating additional costs related to the green transition.
2. First adverse scenario: Focuses on “Run-on-Brown” shocks, where investors divest from carbon-intensive firms, impeding these firms’ efforts to finance green transitions.
3. Second adverse scenario: Builds on the “Run-on-Brown” scenario by adding macroeconomic stressors that amplify transition-related losses.

To quantify the scenarios’ effects, the ESAs and ECB employed top-down models using granular data from 110 banks, 2,331 insurers, 629 occupational pension institutions, and approximately 22,000 EU-domiciled funds, covering loans, equity, debt securities, and fund positions. The time horizon spanned from 2022 to 2030.

Key findings

The results indicate that “Run-on-Brown” scenarios have a limited effect on the financial system, with estimated first-round losses between 5.2% and 6.7% of initial exposures per sector over the eight-year horizon. The most substantial second-round losses occurred in investment funds, totalling 11.2% of starting exposures.

However, under the compounded scenario where “Run-on-Brown” shocks intersect with adverse macroeconomic conditions, potential disruptions increase markedly. Financial institutions experienced first-round losses ranging from 10.9% to 21.5% depending on the sector, with the banking, insurance, occupational pension, and investment fund sectors facing pronounced vulnerabilities. Despite these substantial losses, mitigating factors such as bank income, insurers’ liabilities, and cash holdings by investment funds are expected to buffer the impact on financial institutions’ capital.

Conclusion and policy implications

While the methodological approaches used in the exercise are novel and accompanied by significant data-related uncertainties, the joint effort by the EU institutions underscores the critical need for policies that mobilise sufficient resources for a smooth green transition, while simultaneously addressing and mitigating climate-related financial risks.

The ESAs and ECB emphasised that coordinated policy measures and comprehensive risk management are essential to ensuring financial stability and fostering the green transformation of the economy.