The majority of banks making euro area loans are substantially misaligned with the goals of the Paris Agreement according to research from the European Central Bank, leading to elevated transition risks for roughly 90% of these banks.
The ECB published a report, “Risks from misalignment of banks’ financing with the EU climate objectives,” in January 2024 which reviewed transition risks stemming from banks’ credit portfolios. The bank’s analysis of 95 banks covering 75% of euro area loans showed that credit portfolios are substantially misaligned with the goals of the Paris Agreement.
Frank Elderson, member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, said in a blog that the misalignment with the EU climate transition pathway can lead to material financial, legal and reputational risks for banks.
Elderson wrote: “Through the risk-based lens of a banking supervisor, this is seriously concerning – the longer we wait to transform our economy, the more disruptive the transition and the greater the risks that will materialise on banks’ balance sheets. It is therefore crucial for banks to identify, measure and − most importantly − manage transition risks, just as they do for any other material risk.”
In addition, Elderson highlighted that 70% of banks in the sample could face elevated litigation risks as they are publicly committed to the Paris Agreement.
“It is therefore vital that these banks do more work with their counterparties to ensure the companies they finance do not prevent them from living up to their net-zero commitment,” added Elderson. “This is more relevant than ever, considering that climate litigation has skyrocketed in recent years. Globally, some 560 new cases have been filed since 2021 and increasingly also targeted at corporates and banks.”
The analysis showed that transition risks are largely from exposures to the energy sector, where companies are lagging behind in phasing out high-carbon production processes and are late in rolling out renewable energy production, according to the report.
The ECB said more than 80% of euro area banks have already concluded that transition risks have a material impact on their strategies and risk profiles, but now it is crucial to measure transition risks in a forward-looking manner.
“This is, admittedly, the Achilles’ heel of the exercise considering the relatively carbon-intensive starting point of most economies and the continuous evolution of emission reduction policies,” Elderson added. “But while quantifying the risks is challenging, it is far from impossible.”
The central bank’s forward-looking alignment assessment measures transition risks by comparing the projected production volumes in key economic sectors with the required rate of change to meet given climate objectives over a five-year horizon. The assessment can be repeated over time to determine whether a company is transitioning towards low-carbon production and the pace of transition. The methodology currently includes economic sectors with the most pronounced transition risks that account for 70% of global carbon emissions.
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