Skip to content
White flower
Julia GroteNov 9, 2021 9:25:00 AM5 min read

Climate Change & Financial Market Stability

Climate Change - A Threat to Financial Market Stability in Europe?  

In fall, I like to return to summer - at least mentally, that is possible after all. Join me on my journey to July 2021, when the ECB published a study that caused surprisingly little response. The study states that if the global community fails to meet the Paris climate targets in an orderly transition, the EU financial market will be exposed to significant specific and systemic risks.  

  

WRONG WAY RISK  

Europe is a river-rich area with a strong concentration of valuable industrial operations in single locations in Central and Northern Europe. For this reason, flood disasters have the highest damage potential here. When the water comes, production capacities are destroyed and several problems arise for a bank: the production company can no longer make its payments to the bank, the loan collateral (e.g. a machine hall) loses considerable or complete value, and the loss of jobs also causes employees to default on their private loans. If their financed property is also located in the flood zone, a real wave of write-offs begins for the bank. This is a so-called wrong way risk with a high penetrating power. Currently, only 35% of losses caused by natural catastrophes are insured in the EU. If they become more frequent, premiums will rise or, in the worst case, will no longer be insurable at all.  

DEVALUATION OF CORPORATE BONDS   

A further risk arises from a strong and rapidly rising carbon price, which is currently being discussed at the political level. There is no doubt that a high carbon price has a beneficial steering effect and also solves the problem of fairness: the polluter bears a fair share of the costs incurred by third parties. An abrupt increase, however, would also abruptly drive up the production costs of certain industries and thus presumably lead to a rating downgrade, since ceteris paribus margins would be abruptly reduced, thereby reducing financial strength. Such downgrades are reflected in the bond prices of companies: the price would wall. This abrupt devaluation represents a risk for banks insofar as large banks not only grant loans but also have corporate bonds on their books for trading purposes and liquidity management. An abrupt devaluation of these bonds would lead to immediate losses here. The ECB estimates the potential loss (tail risk) for such a scenario at ten percent of the average bank balance sheet.   

CONCENTRATION RISK   

The risks described (loan default, collateral deterioration, bond devaluation) are not evenly distributed among European financial institutions. 25 EU banks have a full 70% of loans in their portfolios exposed to high or increasing physical risk. For seven of the 25 banks, exposure to such loans exceeds 10% of their total assets. These are relatively large banks (average total assets of €672 billion) that are also potentially exposed to the corporate bond market price risk mentioned above.   

Sounds bad? There is currently no concrete threat to the EU banking sector, as the high capital ratios can also absorb losses from climate risks. However, the study clearly revealed one thing: The biggest threat to our economy would be no climate policy, because even an abrupt transition (an abrupt rise in carbon price to over €100/t) would cost less than the long term damage from disasters caused by uncontrolled global warming. 

RELATED SERVICES & INSIGHTS

Even the best strategy can only be profitably implemented through structured operationalisation. BECEPTUM's services are based on an interdisciplinary methodology in order to actually use innovative ideas to increase the company's value.