“Go beyond the usual climate stress tests”

The EU’s financial regulators will carry out a comprehensive system-wide analysis of the financial sector’s resilience to climate-related risks, and its ability to facilitate financing for Europe’s green transition under stress scenarios, according to a letter by European Commission Financial Stability, Financial Services, and the Capital Markets Union Director General John Berrigan.

The letter, sent to Europe’s three primary financial regulatory agencies, the European Supervisory Authorities (ESAs) – which include The European Banking Authority (EBA), The European Insurance and Occupational Pensions Authority (EIOPA), and The European Securities and Markets Authority (ESMA) – indicates that the analysis will specifically focus on assessing the financial system’s resilience in the transition to the EU’s 2030 goal to reduce greenhouse gas emissions by at least 55% by 2030.

Berrigan wrote:

“To ensure financial stability and to enable the financial sector to play its role in financing the transition, we need to be aware of any potential vulnerabilities in the financial sector and of how stress in the financial system could affect the transition to the 2030 goals.”

Following the launch in July 2021 of the European Commission’s “Strategy for Financing the Transition to a Sustainable Economy,” the regulators and the European Central Bank (ECB) have conducted or planned climate-related stress tests for their respective sectors.

For the new one-off analysis, however, the letter states that the exercise “go beyond the usual climate stress tests,” requesting that the regulators work together, alongside the ECB and the European Systemic Risk Board (ESRB), to conduct a cross-sector assessment, which looks not just at individual sector resilience, but also studies contagion and second-round effects to expose system-wide vulnerabilities. In a more detailed document sent with the letter, the Commission explains:

“The one-off exercise should focus on the EU financial system as a whole. It should assess its resilience until 2030. This will require modelling contagion and second-round effects across firms and sub-sectors of the financial system.”

The analysis is also expected to go beyond examining climate-related shocks, such as the transition risks and physical risks typically studied in climate stress tests, but to also incorporate other stress factors such as the combination of climate-shocks with adverse macrofinancial scenarios used in ordinary financial sector stress tests.

In addition to testing the financial system’s resilience to climate and economic shocks, the Commission also asked that the analysis provide insight into the system’s capacity to continue channeling capital to support the EU’s climate goals. The Commission noted that it anticipates annual additional investments of €350 billion will be needed to meet its 2030 emissions targets. The document stated:

“Such a level of investment cannot be achieved just by public spending. The EU has therefore developed a sustainable finance framework that aims to channel private financial flows into sustainable economic activities.”

The Commission said that the results of the test could be used by policymakers to understand the potential impact of climate-related shocks, and to feed into the regulators’ and central banks’ future supervisory and monitoring programs.

The Commission requested that the results of the test be submitted ideally by the end of 2024, and no later than Q1 2025.