Climate transition: risks and opportunities

Article by Elizabeth McCaul, Member of the Supervisory Board of the ECB, for Eurofi Magazine

7 September 2022

Summer 2022 saw record-breaking heatwaves and forest fires across Europe. Climate change makes such extreme weather events more likely and increases the hot and dry conditions that fuel wildfires. These events, just like the floods seen in Europe last year, remind us of the need to take urgent action to transition towards a carbon-neutral economy. The war in Ukraine has also brought into sharp relief the need to accelerate the green transition and make Europe less reliant on Russian gas and oil, as confirmed by the Commission’s REPowerEU Plan.^[1]

The European Commission estimates that Europe will need around €520 billion in additional private and public investment per year until 2030 for the green transition.^[2] Globally, the International Energy Agency estimates that investments in clean energy of around USD4 trillion annually will be required by 2030 to get the world on track to achieve net-zero by 2050, and that around 70% of that investment will need to be carried out by the private sector. Climate change is not just a risk for credit institutions, it is also a financing opportunity.

At the same time, financial markets are faced with pronounced economic and geopolitical uncertainty. Increasing transition investment might well be a challenge for indebted governments and private firms. The most recent euro area bank lending survey by the European Central Bank (ECB) showed a tightening of credit standards, a trend that banks expect to continue through the third quarter.

Fortunately, despite the macroeconomic uncertainty and difficult market environment, the demand for sustainable investments has remained relatively stable. Sustainable investments continue to grow globally, driven by an increased volume of environmental, social and corporate governance (ESG) funds and green bond issuances. While the bond market as a whole has suffered a significant slowdown in recent months, in the first half of 2022 green bond issuances were comparable to those in the first half of 2021, amounting to USD245 billion globally. During the COVID-19 market turmoil, investors in ESG funds were less sensitive to past negative performance. This suggests that ESG investors might constitute a relatively stable source of financing to support the transition. ECB research has indeed shown that investors are willing to pay a premium for green bonds.

The ECB’s recent climate stress test showed that almost two-thirds of bank income from non-financial corporate customers stems from greenhouse gas-intensive industries. In many cases, banks’ “financed emissions”^[3] are coming from a small number of large counterparties, increasing bank exposure to transition risks, pointing out vulnerabilities in portfolios in terms of physical and transition risks (and missed transition opportunities). In view of the far from negligible income generated from financing carbon-intensive industries, banks must step up their long-term strategic planning.

In order to properly understand their exposure to climate risks, banks need to gain insight into their clients’ transition plans. To be clear, we are not asking banks to divest from carbon-intensive activities. Rather, we are asking banks to fully grasp and manage transition risks in order to make their portfolios more resilient. This means that banks should evaluate what transition entails for their risk exposures to sectors that will continue to be reliant on carbon-intensive technologies for some time and reflect their evaluation in their overall risk management. Not all sectors will decarbonise overnight.

The stress test results also confirmed that timely action pays off. In an orderly transition scenario, where climate policies are introduced early and gradually become more stringent, banks face considerably lower potential losses compared with scenarios where transition policies are phased in late or not at all. This is also in line the ECB’s economy-wide stress test last year, which showed that the advantages of early action outweigh the initial costs over the medium to longer term. Acting now is not only the right thing to do, it also makes economic sense.

Depth and breadth in capital markets are needed to complement bank lending and public investment in order to close the investment gap for the green transition. Research shows that economies with a higher share of equity funding tend to reduce their carbon footprint more rapidly. This is just one of the reasons why the ECB fully supports the European Commission’s Capital Markets Union (CMU) Action Plan.^[4] Initiatives that improve the comparability and standardisation of sustainable finance products, or otherwise enhance the quality and availability of sustainability-related information, will be essential to create a genuinely green CMU and to address the risks of greenwashing.