Institutions and governments are beginning to assess the economic impacts of climate-related risks but the transmission of these risks into the financial system is not well understood. To project how physical and transition risks could seep into the financial system, we analysed potential credit losses for 73 banks operating in the European Economic Area using current pre-provision profitability and the climate scenarios outlined by the Network of Central Banks and Supervisors for Greening the Financial System (NFGS).

Physical risk stems from rising temperatures, sea-level rise, floods, wildfires etc) while transition risks arise from policy shifts towards a low-carbon economy.

“Credit losses could almost triple under an NGFS disorderly transition and hot-house scenario,” cautioned Arne Platteau, an ESG quantitative analyst and author of Scope’s climate study published today. “Economic shocks stemming from climate change could push portfolio returns into negative territory for 21 banks under the disorderly scenario and 19 banks in the hot-house scenario. The most vulnerable banks are located in Southern and Eastern Europe. We project the worst affected banks could face additional annual losses exceeding 250bp, mainly due to higher projected physical risk exposure.”

While banks can risk-manage their balance sheets and margins, the magnitude of potential losses means they will need to develop robust transition plans to adapt to evolving circumstances and mitigate the associated risks of climate change.

“Our analysis supports regulatory efforts aimed at increasing banks awareness of climate-related risks, including their mapping and measurement, and indicates a need for increased climate risk management,” Platteau continued. “The geographic concentration of losses also needs further monitoring to prevent the build-up of potential pockets of systemic risk.”

In order to gauge the potential impact of climate risk on large European banks, we constructed a synthetic profile based on the geographic and segment distribution of the credit exposures of banks with total assets above EUR 500bn that participate in the European Banking Authority’s transparency exercise. Most exposures are focused on Europe, though North America comprises a non-negligible proportion of exposures. In terms of lending segments, the portfolio is evenly split between corporates, government/public sector, and retail.

“Pre-provision profitability lies at 102bp of interest-bearing assets, whereas the cost of risk before considering climate risk amounts to 34bp, leaving the bank with a baseline pre-tax credit portfolio return on assets of 68bp. However, when we add additional losses from climate-change risks, cROA further decreases,” Platteau said. “In the orderly scenario, we expect an additional 51bp of annual credit losses in the long run. In the disorderly and hot house scenario, credit losses could almost triple, with an additional 63bp and 58bp of credit losses each year in 2045-2050 respectively, almost wiping out the bank’s profitability.”

Download the full study here.