The European Union is fretting about the financial stability risk of the climate transition.
As it implements its world-leading Fit for 55 package to cut greenhouse gas emissions 55% between 1990 and 2030, profound changes to the economy could trigger sudden, disorderly market crashes. Investors might suddenly dump old economy, high polluting assets such as oil and gas producers or fossil fuel-fired power stations.
The European Commission asked its three financial supervisory authorities as well as the European Central Bank and European Systemic Risk Board to conduct a risk scenario analysis to model what could happen. This week they reported.
It was an unprecedented effort — the first EU-wide climate stress test for the financial sector, modelling what would happen to 110 banks, 2,300 insurance companies, 600 pension funds and 59,000 funds.
Three scenarios were considered over an eight year horizon: a baseline of an orderly transition in benign economic conditions; an ill-named ‘run on brown’ scenario in which investors flee high carbon assets; and a worse version of that when there are also macroeconomic stress factors.
All would produce losses to the financial system: €1.2tr, €2tr and €5tr respectively. In the worst case, this is about 21% of the value of the affected types of asset. The damage is much smaller relative to total assets. Nevertheless, “adverse macroeconomic developments could disrupt the evolving transition and substantially increase financial institutions’ losses, thereby impairing their financing capacity”.
Fair play to the authorities — it’s their job to think about such risks. But worrying about the financial effects of a sharp low carbon transition is a bit like the captain of the Titanic wondering how much glassware would be broken if he turned sharply to avoid the iceberg.
The whole exercise, the authors say, assumes that the Fit for 55 package will be “fully implemented as planned and that its objectives will be achieved by 2030”.
The EC believes it is on track to achieve the 55% target, having got emissions down 37% by 2023. But that leaves a 29% cut from the 2023 level to be achieved in the next six years — nearly 5% a year, compared with an average of 1.1% between 1990 and 2023.
Progress has accelerated, but it is a huge ask, and climate action has become vehemently politicised. All over Europe right wing parties are fighting for less action and even to reverse green policies.
But the effects of straying off track and missing the 55% target would be devastating. If the EU cannot cut emissions by something approaching an adequate pace, who else is going to?
If any of the stress test scenarios really do happen and Europe lowers emissions 55%, whatever the financial losses, there should be dancing in the streets.