Lots of smoking chimneys in a dark environment

The latest attempt to stress test banks’ climate-related financial risks by the European Central Bank (ECB) highlights the challenges in addressing these risks, says Fitch Ratings.

In a new report, the rating agency said that the results of the ECB’s climate-risk stress test for 2022 revealed both the limitations of these kinds of exercises, and the size of the challenge facing banks, which remain closely aligned with high emission sectors.

To start, the test highlighted the shortcomings of climate data, which meant that many of the calculations used in the ECB’s latest test were based on estimates, Fitch said.

“For example, only 20%-30% of the data for the greenhouse gas (GHG) emissions of counterparties were based on actual figures,” it reported.

These kinds of limitations mean that regulators are not yet prepared to use the results of these tests to start imposing capital charges for climate risks, Fitch said.

At the same time, Fitch said that the ECB’s stress test also highlighted the extent to which bank lending is reliant on sectors with high emissions.

“Participating banks received more than 60% of their interest income in 2021 from corporate customers operating in 22 high GHG-emitting sectors,” it said.

Additionally, the test found that only about 40% of the participating banks had well-integrated stress-testing frameworks, and the vast majority (about 80%) did not consider climate risks when granting loans, it noted.

Moreover, about half of the banks received the lowest score for governance under the ECB’s climate stress-testing framework.

“The findings may reignite questions on the difficulties banks face in decarbonizing their balance sheets, and how quickly borrowers in high-emission sectors will be able to transition to a low-carbon economy,” Fitch noted.

Looking ahead, the rating agency said that it expects climate stress tests to “become more meaningful as banks expand their climate-related data collection.”

Future climate stress tests should benefit from the availability of more up-to-date scientific data and carbon pricing data, Fitch said.

In the meantime, the results of the latest test should provide some insight on climate risks to regulators, it noted.

“The ECB will consider the qualitative findings from its stress test, combined with its ongoing review of how banks incorporate climate and environmental risks into their strategies, governance and risk management, when conducting its 2022 supervisory review and evaluation process,” Fitch said.