Climate change is one of the most pressing issues of our time, and its impact on the financial system is a growing concern. A report by the European Commission published on 1 July sheds light on the risks that climate change might pose to financial stability in the European Union and takes stock of ongoing EU policy initiatives.
The report compiles data which shows that climate risks could lead to losses for financial and non-financial companies. It covers impacts on various parts of the financial system, including banks, insurers and investment funds. For example, based on 2023 stress tests from the European Central Bank, the median EU bank faces losses of 0.6 to 1% of its total portfolio over a modelling horizon of 8 years, though the estimates in the report should be seen as a lower bound of the actual impact.
The report is part of an ongoing learning process by regulators, supervisors and industry.
Why is climate change a financial issue?
Climate change is not just an environmental problem; it can have significant implications for the economy as a whole – including the financial system. Rising temperatures, more frequent natural disasters, and changing weather patterns can all have a major impact on businesses, economies, and financial markets. For example, a company that relies on fossil fuels may see its profits decline as governments implement policies to reduce carbon emissions. Similarly, a bank that lends to companies in areas prone to natural disasters may face significant losses if those disasters occur.
What are the key risks?
The report takes stock of existing research identifying two main types of climate-related risks: transition risks and physical risks. Transition risks arise from the process of transitioning to a low-carbon economy, such as changes in policy, technology, and market sentiment. Physical risks, on the other hand, result from the physical impacts of climate change, such as more frequent natural disasters and rising sea levels.
How is the EU responding?
The EU has made progress in addressing climate-related financial risks. The report highlights several key initiatives, including the development of a comprehensive framework for disclosing climate-related information by financial institutions and companies and the new prudential requirements for banks and insurers to integrate climate, and more generally ESG, risks into their risk management systems. The Sustainable Finance Disclosure Regulation (SFDR) requires market participants to disclose how their investment decisions affect people and the environment and how they manage sustainability-related risks, including climate-related risks. The Corporate Sustainability Reporting Directive (CSRD) extends mandatory reporting requirements to all large companies established in the EU and all listed companies in EU regulated markets to disclose information on sustainability aspects. Regarding prudential requirements, the banking package that will apply from 1 January 2025 and the reviewed Solvency II Directive require banks and insurers to factor in climate-related exposures and risks in their regular supervisory risk and solvency assessments.
The EU has also established a taxonomy for sustainable activities, which provides a common language and set of criteria for determining whether an economic activity is environmentally sustainable. The financial sector will provide specific key performance indicators such as the green asset ratio for banks/credit institutions or the green investment ratio for asset managers. Based on new standards, the banking and insurance sectors will disclose the exposure to and the management of climate risks.
Using these new tools, investors and financial institutions can make informed decisions about their investments and identify opportunities for sustainable growth.
What does this mean for you?
The Commission could build on this report’s findings and ongoing analytical work such as the Fit‑fo‑55 exercise to continue monitoring the situation and assess possible further improvements to the EU regulatory framework.
As the EU continues to address climate-related financial risks, individuals and businesses can expect to see changes in the way financial institutions operate and invest. This may include more transparency and disclosure about climate-related risks and opportunities, as well as new investment products and services that support sustainable growth.
In the long run, addressing climate-related financial risks will help to ensure the stability and resilience of the EU's financial system, which is essential for economic growth and prosperity.
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Details
- Publication date
- 9 July 2024
- Author
- Directorate-General for Financial Stability, Financial Services and Capital Markets Union