Along its green transition path, Europe's financial stability is truly at risk only in the case of combined effects with macroeconomic shocks. This is the outcome of the stress test conducted by the ESAs and the ECB.
The Fit-for-55 climate stress test requested by the European Commission assesses the resilience of banks, insurers, pension funds, and investment funds to both climate and macroeconomic shocks.
The test shows that transition risks alone do not threaten the financial stability of the EU. However, when combined with macroeconomic shocks, the losses increase and can become significant. This is the result of the first climate stress test, which evaluates the impact of potential shocks in a scenario where the full implementation of the Fit-for-55 legislative package—the cornerstone of the Green Deal presented in 2021—is assumed. To date, the legislative process in Brussels has concluded, and all measures have been approved.
What impact would a financial shock have on the European transition? How significant are these risks for the financial stability of the bloc? These questions are answered by the simulation conducted by the European Central Bank (ECB) and the three supervisory authorities (EBA, EIOPA, and ESMA, collectively known as the ESAs). The test involves 110 banks, 2,331 insurers, 629 professional pension funds, and approximately 22,000 investment funds, covering the period from 2023 to 2030.
How Did the First Fit-for-55 Climate Stress Test Go?
The impact of transition risks on financial institutions is “limited,” according to the report. In the ECB’s definition, transition risk refers to the financial losses that an entity may incur, either directly or indirectly, as a result of the adjustment process towards a low-carbon economy that is more environmentally sustainable.
The estimated losses are at most 5.2%-6.7%. These figures come from the simulation conducted in the first scenario, which assumes the implementation of Fit-for-55 under stable economic conditions. These figures reflect the first-round impact (on individual sectors) and second-round impact (cross-sectoral, reflecting contagion and amplification risks).
However, scenarios combined with macroeconomic shocks can lead to much heavier losses, ranging from 10.9% to 21.5%. These figures emerge from the other two adverse scenarios, which include “Run-on-Brown” shocks, one of which is amplified by macroeconomic factors.
In these scenarios, a sudden shock is assumed that changes the trajectory of the transition, in the form of a fire sale of high-carbon assets, followed by difficulties for “brown” companies in accessing funding to make their operations more sustainable.
How to Mitigate the Worst-Case Scenarios?
The Fit-for-55 climate stress test indicates the need for “a coordinated political approach to financing the green transition” and suggests that it would be beneficial for financial institutions to “integrate climate risks into their risk management in a comprehensive and timely manner.”
