Climate change affecting banks
Szeplaki Agnes
Climate change and its potential consequences are becoming more widely recognized in scientific and popular circles. Climate change is manifesting itself in a variety of ways, ranging from the widespread appearance of bugs in Hungary to special litigation, such as that filed by the state of New York against Exxon.
The fact that the impact of climate change is becoming a more important factor in the assessment and exploration of banking system risks demonstrates the topic’s significance.
Recently, the Dutch central bank published a detailed study (Vermeulen et al. 2018) on how to account for the medium-term effects of climate change in bank stress tests. Before delving into the effects, it is worth discussing briefly what the stress test covers for banks. They are used in a variety of industries to determine whether or not a product can function properly even under extreme conditions.
Many people are certainly familiar with the image of a large number of heavy vehicles being diverted to Elizabeth Bridge to test its load capacity. Banks use similar models to determine whether their capital levels are adequate or solvent in the event of an extreme economic environment.
Climate change can also lead to severe economic conditions. The Dutch central bank conducted research to develop scenarios along two dimensions for its new stress test. One of these was the shift in regulatory attitudes, which determined whether an active, interventionist policy emerged or whether the decision-maker remained passive.
The other factor was technological progress. Other consequences should be considered in the event of a potential technological breakthrough (for example, in renewable energy storage) or if this does not occur. According to a study conducted by the Dutch central bank, there are four different scenarios in which bank stability should be examined along these two dimensions.
Regulatory shock: Several regulatory options could increase the relative cost of CO2 emissions (e.g., drastic taxation of CO2 emissions). If such a change were implemented abruptly and on a large scale, the economic environment would suffer significantly.
Rising energy prices would raise production costs, reducing corporate profitability and driving inflation higher. Stock prices and the rate of return on investment will fall as a result. Higher prices and sluggish economic activity would impact consumption, slowing economic growth in the long run.
If the scenario is realized, annual growth could be 1–2 percentage points lower over the next five years.
Technological Shock: Even technical factors (such as efficient storage) obstruct significant growth in renewable energy sources. The removal of such barriers as a result of significant technological advancement would fundamentally alter the current economic scene.
On the one hand, the switch would result in investments in renewable energy sources and related industries; on the other hand, it would result in massive losses in the extraction of fossil fuels and closely related industries.
Consequently, the impact on the macro-environment is unclear. According to the Dutch central bank’s model, new investments would even improve the economy in the first year. But it would slow down more than in the baseline scenario in the second and third years.
However, by year four, positive growth effects would be back.
Combined Shock: In the third scenario, the first and second shocks would occur simultaneously. This would mean that the drastic impact of the first scenario would be mitigated by technological innovation.
Accordingly, the effect would be between the two, i.e., after a short-term positive shock, 3 years of weaker economic performance could be expected before the positive effects prevail again in 5 years.
Confidence Shock: The first three trajectories show that, even if a positive technological shock occurs, the medium-term macroeconomic impact is unknown. The fourth scenario is critical because it demonstrates that inaction can have the same negative consequences as a regulatory shock.
A combination of regulatory inertia and a lack of innovation causes a confidence crisis, which is accompanied by a significant drop in consumption and investment. As a result, growth would be 1–2 percentage points lower in the medium term than in the baseline scenario, similar to the first scenario.
The assessments of the Dutch central bank indicate that the Dutch financial sector would be able to endure these situations. Despite the high amount of initial capital, the high level of possible losses allows for stability to be maintained in such a circumstance (individual banking results may vary depending on the direct exposure to the sectors concerned).
The act of carrying out the exercise sends out rather critical messages.
On the one hand, it emphasizes the importance of banks being prepared for similar scenarios as well as the specific risks of the sectors in question.
On the other hand, it sends a strong message to decision-makers that delaying regulatory action is just as risky as taking drastic action right away. Furthermore, delays in decision-making will necessitate increasingly drastic changes in the future, which may have a far greater immediate impact than currently estimated.
Vermeulen, Robert, Edo Schets, Melanie Lohuis, Barbara Kölbl, David-Jan Jansen és Willem Heringa (2018): An energy transition risk stress test for the financial system of the Netherlands, De Nederlandsche Bank
