European Regulators Call for Stronger Climate Risk Integration Following Stress Test Findings

The European Supervisory Authorities (ESAs) have released the results of the “Fit-For-55” climate stress test, assessing the resilience of banks, investment funds, and the pension and insurance sectors to the transition to a low-carbon economy. The stress test, commissioned by the European Commission, aimed to determine the financial sector’s capacity to withstand the pressures of Europe’s green transition and its 2030 goal of reducing greenhouse gas emissions by at least 55%.

The stress test results indicate that while transition risks alone are unlikely to pose a systemic threat to financial stability, specific adverse scenarios could still lead to significant financial losses and disruption. Regulators emphasized the need for a coordinated policy approach to finance the green transition and urged financial institutions to comprehensively integrate climate risks into their risk management processes.

The analysis, conducted by the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA), and the European Securities and Markets Authority (ESMA), examined three potential scenarios. These included a baseline scenario where the “Fit-for-55” initiative proceeds as planned, an adverse “Run on Brown” scenario featuring a sudden shock that leads to the selloff of carbon-intensive assets, and a more extreme “Run on Brown” scenario combined with macro-financial stress factors.

In the first “Run on Brown” scenario, the impact on the financial system was found to be limited, with investment funds bearing the heaviest losses at 11.2% of their exposure when contagion effects were modeled. However, under the more adverse scenario involving macro stress factors, losses across the financial system could substantially increase, impairing financial institutions’ ability to finance the green transition. Investment funds were again projected to suffer the most, with losses reaching 25%, as they are particularly vulnerable to market risk.

Overall, the stress test estimated potential “first-round” losses of approximately €3.9 trillion under the most adverse scenarios, with additional losses of €1.2 trillion when taking contagion effects into account. These findings highlight the need for financial institutions to bolster their risk management and emphasize the importance of a coordinated policy framework to support the transition to a sustainable economy.

The ESAs’ report underscores the evolving role of financial institutions in navigating climate-related risks and facilitating a resilient and well-financed green transition. A proactive approach to integrating these risks will be crucial for ensuring the stability of the financial system as Europe progresses towards its ambitious climate goals.