EU Regulators Spotlight Climate-Related Financial Stability Risks

A joint report published today by the European Central Bank (ECB) and the European Systemic Risk Board (ESRB) finds that the combination of physical climate hazards, a significant insurance pricing / protection gap, and financial markets moving to reassess and reprice assets amidst increasingly clear transition risks could create risks to the stability of the EU financial system.

The ECB/ESRB analysis shows that the share of carbon intensive sectors in EU bank lending is around 75% higher than its equivalent share in overall economic activity, and 60-80% of all mortgage lending in the euro area is to high-emitting households. Furthermore, only 25% of average climate-related losses are currently insured, and the report warns of inadequate pricing and coverage for future climate risks.

On catastrophe risk, the report cites the importance of healthy reinsurance markets - in conjunction with capital market instruments like ILS and Cat Bonds - to manage and diversify risk across the economy. That said, the authors caution that the industry faces challenges in pricing risks adequately and thus propose an EU-wide public natural disaster insurance scheme that they argue would cover a broad range of hazards, reduce economic costs, accelerate recovery efforts and incentivise risk reduction through mitigation and adaptation measures.

Taking into account broader climate-related environmental impacts, the report notes that 75% of EU bank loans and over 30% of insurer investments in corporate bonds and equity are in economic sectors heavily reliant on ecosystem services (including for example those related to erosion control and flood/storm protection) that are exposed to climate impacts.

In response, the ECB/ESRB makes the case for a system-wide macroprudential approach that includes non-bank financial intermediaries (and in particular insurance gaps) and draws on existing, scalable tools like systemic risk buffers and risk concentration limits. The proposed framework would include (i) gathering evidence on the most important financial stability indicators via a surveillance framework and accompanying Chartbook, (ii) leveraging this evidence to develop a macroprudential strategy for addressing climate risk, and (iii) extending the scope from climate-related risks to broader nature-related risks.

The report is available here: https://www.esrb.europa.eu/pub/pdf/reports/esrb.report202312~d7881028b8.en.pdf

Source: European Central Bank (ECB), https://www.ecb.europa.eu/press/pr/date/2023/html/ecb.pr231218_1~6b3bea9532.en.html