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ECB Climate Risk Stress-Test: A Learning Exercise

In this commentary, DBRS Morningstar looks at the ECB’s 2022 Climate risk Stress-Test (CST) published on July 8, 2022. Overall, there are no implications on European banks’ credit ratings nor European sovereigns’ credit ratings from the CST at this stage. This is due to the nature of the exercise which we view as being a learning exercise to enhance both the European banks involved and the ECB’s capacity to assess climate risks.

Key highlights:

-- The CST was designed as a bottom-up exercise assessing transition and physical risks. The ECB has also carried out thematic reviews and DBRS Morningstar notes that this is the first time we have seen the introduction of severe physical shocks and their assessments over a short-term period.

-- A pioneering learning exercise which was based on the banks’ own data submissions and stress-test projections. However, ESG disclosures are not yet mandatory, and many European banks have used proxies to bridge the gap, while their modelling techniques were lacking in many cases.

-- Before repeating this kind of exercise, the majority of European banks involved were told by the ECB they need to enhance their climate-risk stress testing capabilities. To that end, the ECB will publish in H2 2022 best practices and recommendations how to overcome some of the issues it has observed.

-- From a financial stability perspective, the CST, even as a learning exercise, builds on the ECB’s capability to assess systemic financial risks, as part of the financial supervisor’s toolkit.

“The ECB emphasized last year the impact of climate risks across the banking sector could represent a major source of systemic risk, particularly for banks with portfolios concentrated in certain economic sectors and specific geographical areas, however, the CST did not provide detailed indications on the geographies potentially affected under the selected scenarios. Instead, it made clear that the majority of participating European banks need to enhance their climate risk stress testing capabilities”, said Vitaline Yeterian, Senior Vice President, Global FIG.

Adriana Alvarado, Senior Vice President in the Global Sovereign Ratings Group, added: “With the CST aiming to help monitor systemic risks in the financial system in Europe, the exercise adds to the ECB’s toolkit. That said, some shortcomings continue to pose a challenge to the ECB’s ability to assess the accumulation of climate-related risks”.