Both firms and banks “clearly benefit from adopting green policies early on to foster the transition to a zero-carbon economy,” according to the European Central Bank (ECB), which has published results of an economy-wide climate stress test. The exercise tested the impact of climate change on more than four million firms worldwide and 1,600 euro area banks under three different climate policy scenarios. It addressed physical and transition risk and found that an “orderly and swift transition” to minimise costs and maximise benefits “outweighs short-term cost of transition to zero-carbon economy over medium to longer term”.
It found that in Europe, physical risks are unevenly distributed, with the north prone to floods and south exposed to heat stress and wildfires. It said, “Firms in regions most exposed to physical risk could face very severe and frequent natural disasters, which would in turn affect their creditworthiness.”
Transition risk is the cost of introducing policies to reduce CO2 emissions, particularly for certain high-emitting industries. The ECB found that despite the short term cost and risk for carbon-intense industries the transition to a greener economy is “a golden opportunity”. The exercise shows that the advantages of taking action early on outweigh the initial costs over the medium to longer term. More benefits arise from energy efficiency gains for firms and cheaper energy prices overall.
Euro area banks could be severely affected if climate change is not addressed, the ECB said. Losses on corporate loan portfolios would rise significantly over time, driven by increasing physical risk. In 2050, the average corporate loan portfolio of a euro area bank is more likely to default under a ‘hot house world’ scenario than under an orderly transition.
When distinguishing between different loan portfolios, the climate-induced impact becomes even more pronounced, and particularly over time. Compared with an average portfolio, under the ‘hot house world’ scenario portfolios most vulnerable to climate risk are five times more likely than to default in 2050.
“Without policies to transition to a greener economy, physical risks will increase over time. They will increase non-linearly, and due to the irreversible nature of climate change, this increase will continue over time. It is essential to transition early on and gradually, so that we can mitigate the cost of both the green transition and the future impact of natural disasters”, said Luis de Guindos, Vice-President of the ECB.
Read more from the ECB research here