 You're listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Katie Ranger. 2021 is widely seen to be the make or break year for climate action. The countdown is starting for the United Nations COP26 conference in November in Glasgow and expectations are high. In July, we at the ECB revealed an ambitious roadmap for taking climate change into account in our work following our strategy review. And today, we've reached one of the key milestones on that roadmap, the results of our first economy-wide climate stress test. I'm speaking to our Vice President, Luis de Guindos, about the results of the stress test and what they mean for people, companies and banks. So, again, welcome to the digital class right now, Luis de Guindos. Hello, thank you very much. It's a pleasure to be here with you. Now, it's probably right for you to explain stress testing as a tool that we typically use in our role as a point-fitting supervisor to gauge how strong banks are in the age of shock. Now, the principle for the latest stress test is essentially the time we are assessing climate change. But here, we're looking specifically at what's called my climate change, and this time around, we've all joined the company in our analysis so that we can assess the economy of that economy. Luis de Guindos, what can you tell us about the kind of news we're doing with the digital class? Well, first of all, you are totally right. That's the main goal of our climate stress test. And if I have to summarize the main conclusion and to put it in a sort of a nutshell, I would say that we need to act today because the costs will only increase tomorrow. That's the main conclusion. That's the main point that we are making. We have to act now, and our stress test findings support this even more. Concrete findings that I think that we should go to very concrete and specific points. Climate impacts are concentrated in some geographical areas and sectors. For instance, we have the example of this summer. Countries in the south of Europe are particularly exposed to heat waves and wildfire risk, while north European countries are much more prone to flood risk. When talking about physical risk, sectoral differences matter less than geographical location. Our transition risk sectors play a much bigger role, though. We found that that mining, agriculture and electricity companies could be the most impacted. Stress tests really are a key tool for us central bankers. One of the big challenges with climate change is that while we do know that it affects the financial sector, the concrete risks are currently not understood well enough. The climate shock differs a lot from previously financial crisis and can materialise over longer pre-tine horizons, so very far in the future, between 30 and 50 years. Stress tests help us better understand what climate change can mean for people, companies and banks. The economy, as we have said, as a whole. Very interesting and above all, career for adults indeed. Now, we've talked a little bit about the what, let's talk about the how. The setup of these stress tests is new and quite different from past exercises conducted by other central banks. Can you explain a little bit about how it was conducted? Well, I think that this is quite that unique stress test, and as you have said before, it's different from, let's say, financial consideration stress tests. This one is much more tailor-made in order to try to pick up the costs of climate change. And it's quite unique in scope and methodology. Starting on the scope, it was an economic-wide stress test. This means that we don't look only at banks, we also include companies. In fact, it was the largest of its kind, looking at 4 million companies worldwide and more of 1,600 banks in the Euro area. So the level of richness of the database is huge. And we looked at the time horizon of 30 years into the future. This is the most comprehensive collection of climate and financial data in a central bank. On the approach, this is different to other exercises. We performed a centralized stress test. This means that we didn't ask banks to self-assess the potential impact of climate change on the balance sheet. But we performed this calculation ourselves for all banks, and companies in our samples. This way, we were sure of the consistency in the approach. It also allowed us to look at such a large number of companies and banks. And finally, on the methodology, for these 30 years, we looked at three scenarios and what they could mean in terms of the impact on banks and companies. The first is the best case, what we call the best case scenario. Climate policies are put in place in this scenario in a timely and effective manner. The second one is what we call a disorderly transition scenario. Measures are put in place, but late. And finally, the worst case, that is what we call the hot house goal scenario. No policies are implemented, no action is taken. So, just to go back, you mentioned that this is a centralized stress test, and our experts often call it a top-down stress test as opposed to a bottom-up. And that's this idea that the data is collected centrally quite fast, rather than it being provided by the banks and companies themselves, as we traditionally do with the supervisory stress test. You are totally right. The top-down is that we have our information, and we make a sort of comprehensive assessment for the whole sector. But we don't receive the data from the banks or the companies. So, I would say that perhaps this top-down or centralized exercise is much more, let's say, neutral than the bottom-up. The bottom-up is when we ask to the companies, we ask to the banks. So, in that respect, the outcome, we can say that is not affected by any sort of bias in terms of the answers and the responses of the banks. Now, you've also mentioned the three different scenarios that we looked at and the effects of them. And what in fact we've already seen over the past month that climate change can indeed have tangible and dramatic consequences. But it does seem that we, as a society, are lagging behind on taking action. Why is it so difficult to set the green transition in motion? Obviously, the bulk of the responsibility lies with government. But what is actually the company from banks actually doing to get this going? Well, I think that this is a very important issue, the one that you have mentioned. What are the costs of investing in doing things differently today? And how do they compare, for instance, to the longer costs that will arise from climate change? These are the two main questions that we have to ask ourselves. We urgently need to transition to a greener economy. And there are different ways of financing this. We have taxes, we have incentives. Even we can put a price on carbon emissions while there are different ways. But we shouldn't forget that the transition also comes with a lot of benefits. First, technological developments can bring energy efficiency and revenue gains for companies and banks. And second, acting now helps us avoid future costs due to the increased physical risk. As for examples, you know what the floods and the wildfires that I mentioned before. Examples of what banks and companies can do, they can invest in green technologies, for instance, make their production change and processes much more sustainable over time, shift their portfolio investments towards green counterparts. Our climate stress test captures all these aspects in the modeling framework. If policies to transition towards a greener economy are not introduced, physical risks become increasingly higher over time. They will increase exponentially. And due to the reversible nature of climate change, such an increase will continue over time. We really need to start this transition now to mitigate the costs of both the green transition and the future impact of natural disasters. That's perhaps not the main message that we can send. Well, we found that climate change is a major source of systemic risk, particularly for banks with investments concentrated in sectors and regions highly exposed to climate threats. For example, imagine an area with a lot of industry that is located near a coast or a river. We have so many of them here in Europe, think in the Netherlands, for example, the north of Germany or even Italy. With climate change, extreme weather events are becoming more frequent. We have seen terrible floods in central Europe this summer which cost a lot of damage to people, companies, to the whole infrastructure. The same goes for the wildfires in Greece and other southern countries, for instance, I come from Spain and we have had quite a few of them. What does this mean for banks? Banks give out and grant loans to people and companies living in these affected areas. The effects of floods and wildfires can lead to people not being able to pay back these loans, which in turn means losses for the banks. The impact on banks' expected losses is mostly driven by physical risk and it is expected to become more severe over the next 30 years. This is why an orderly transition to a greener economy is so important and so beneficial for companies and for banks at the end. This stress test is a very relevant part of the ECB's action plans, to consider climate change in our work as a central bank. Climate change can affect financial stability, as our stress test shows, but also price stability, which is, as you know, our primary mandate here at ECB. Therefore, we are committed to do our part within our mandate to tackle it. This action plan is one of the outcomes of our big strategy review and was announced earlier this summer in July. We put a lot of attention and a lot of emphasis on climate change in our strategy review. The action plan looks at all the different aspects of our work. It covers how to consider climate change in our monetary policy operations, how to better understand climate risk in our micro-economic models, how to check banks and companies' exposure to climate risks, as well as our own exposure. For example, the climate stress test methodology that we have used and the results that we have obtained will fit into two other important ECB stress test initiatives. The first one will be the supervisory climate stress test, that it will be using our terminology, a bottom-up. We will ask the banks and afterwards we will aggregate the responses of the banks. And finally, we are going to also to stress test our own balance sheet. Before we wrap up, we always ask our guests for a hot tip next to the topic we are discussing today. What tip would you like to share with others on the topic of climate change? Well, it's difficult to give a tip, no? But in my case, well, I have two granddaughters, five and two years old. And perhaps, you know, whenever I deal with this kind of things, I try to look for, let's say, a human aspect, a human consideration. And I think that sometimes, you know, I think that perhaps the best legacy that I can give to my granddaughters is, you know, a clean planet, a planet that is dealing with the problem of climate change. And I think that, you know, this, you know, solidarity with future generations is perhaps, you know, one of the main aspects that I would like to recall and to bring to the fore. Because I think that sometimes we do not consider that our actions are going to produce consequences in the future. So everything that we do in order to fight climate change is paving the way for, you know, a better world for the future generations. Thank you very much. Bye-bye. Let's now look more generally at our commitment here at the ECB in the fight against climate change and the next steps on the action plan that we've already touched upon. I'm joined now by the head of the Climate Change Center here at the ECB, Irina Hemskerk, who joined in June when the center was set up. Irina, welcome to the ECB podcast. Nice to see you joining virtually from Amsterdam. Thank you so much, Katie. A pleasure to be here today with you. Now, Irina, you've been setting up the Climate Change Center since it was established and you were appointed as its head in June. Now, perhaps you can tell us a little bit about the center's purpose. What's the idea behind it? Yeah, so how I see the purpose of the Climate Change Center is really to shape and steer the ECB's climate agenda as we start to tackle the issue with more and more urgency and determination and to able to realize this. The Climate Change Center, we will focus on three things. First is coordination. We bring together the work that is being done on climate issues in different themes across the ECB from statistics, monetary policy, economics, financial stability, and so on and so on. So like really connecting the people and the content. Our second focus is strategy. So we are creating an overview of all the climate-related activities inside ECB and we're also monitoring the developments that are happening outside in the markets and at the political level. On this basis, we identify priorities to enhance the ECB's strategy to address climate change. Thirdly, and lastly, we have a central role in steering the work across the ECB in order to implement the strategy and reach the climate priorities that we've agreed on. So it's kind of like bringing it all together and driving it forward at the same time. It sounds like you're going to be really, really busy over the next few months as work really starts to get going. How's it going so far? I mean, to what extent is the center already up and running? Yeah, so I joined in June, so indeed, still pretty fresh on the job and most team members just joined last month. This of course means that we are still a bit in the startup phase of our work as we can build upon, but yet as we can build upon the climate work already done, I do expect we can be quickly up to speed. Okay, Irina, I'm curious to know what kind of people you're actually working with in the climate change center and what kind of profiles you're looking at. Maybe you can take us a little bit behind the scenes because, well, I've got to be honest, I have this kind of idea of a central banking expert that's also a climate scientist and knows everything about the environment as well at the same time, but that's probably quite unrealistic. So maybe you can just give us a bit of an insight into what kind of people you've got in the team there. Yeah, happy to do so. And to start off with, in total, we will be a team of 11 people and will be a very diverse group as typical for the ECB. My colleagues are from different countries across Europe and we all bring in different perspectives with various backgrounds. Five experts in the team are seconded to the climate change center from these different areas within the ECB. They are really their liaison between the technical work that is happening in the different business areas and the climate change center. They are key for the coordination. And then we have three team members focusing on horizontal topics. So one is communication, the other one data, and what you mentioned also climate science. We are still in the process of hiring a climate scientist, but I believe it will be quite unique and yet also very much needed to have someone in the team that can help us better understand how the climate is changing and the effects it will have on the economy as well on the financial sector. The other three team members are the deputy head, the assistant and myself. We are there to ensure everything is managed smoothly and we can deliver on the expectations. And I'm just really pleased that the team is almost complete and the colleagues are just a pleasure to work with. They're all very highly motivated and great experts in their fields. But next to the great people I work with, what I also really like about my job is that the work of the ECB has moved beyond acknowledging the importance of addressing climate change. So the work now is more in a stage of focusing on implementation and action. And I'm just very much motivated to contribute to that. Let's focus on what you've just mentioned, Irina, the work itself. And Vice President Deguindos mentioned earlier in this episode that the stress tests, the results of which came out today, was just one part of our climate action plan. Another are the stress tests that we'll be conducting next year on climate risks for banks, so on the supervisory side of things and also for our own balance sheet. What are the next steps on these two tests? Yes indeed, two other stress tests are planned for next year and they will be based on the methodology and results developed for the economy-wide climate stress test that was published today and introduced by the Vice President already. But firstly our banking supervisors, they will be looking at how banks self-assess their own climate risk. So the idea is to test how prepared banks are to assess climate risk but also to understand their potential vulnerabilities to climate risk. And the results of this stress test, this so-called bottom-up stress test exercise, they will also be used to inform their annual supervisory review process. Officially we call it the supervisory review and evaluation process or in short SHREP. And the preparatory work for these stress tests has already started. Today's result of the economy-wide climate stress test offer a useful basis for the different scenarios our supervisors will be testing the banks against. And now I could also say something about the other stress tests we're doing on our own balance sheets. So we are currently collecting data and specifying the methodology for a climate stress test in 2022 of the Euro system balance sheets. This is the first time we'll assess our own risk exposure to climate change and this stress test will also be based on today's results. So in total we will execute three different stress tests, the top-down economy-wide stress test that was published today and next year on supervisory site and also on the Euro system balance sheet. Let's talk a little bit about our core business now, monetary policy. In this area we hear quite a few demands that we should be taking a bigger role in the fight against climate change and that some of these are quite unrealistic given that we're a central bank. In fact, executive board member Frank Elderson said on this podcast back in May, we are the policy taker here, not the policy maker. And governments are essentially the ones primarily responsible for fighting climate change. That being said, following our strategy review, we did pledge our commitment to include climate change considerations in our monetary policy framework. And one element that people look at quite closely there is our corporate bond purchases. Irina, what concrete steps are we taking here? Yeah, before diving into these two concrete steps, I think it's good to emphasize that at the ECB we take climate changes very seriously. Governments do have more powerful tools at hand to combat climate change than we as central banks do. That's true. But we are convinced that every policy maker needs to contribute to tackling this global challenge. With the tools it has at hand and the mandate it has been given. So our action plan on climate change and monetary policy very much reflects that. Concretely, the two actions I want to mention related to our corporate bond purchases. The first one, the first action is taking into account climate risk in our own financial risk assessment. We want to reduce the risk that we face as an asset holder. That's what we need to do to consider climate change as one risk aspect in our due diligence procedures for our corporate asset purchases. This we have already started to do. Secondly, we start to do more analysis if and how we could include climate-related eligibility criteria in our corporate asset purchases. So what does this mean? For example, we look at whether the issuers of corporate bonds that we hold or want to buy or are complying with the Paris Agreement or similar goals to reduce emissions. This is not something that we can implement overnight. We will first have to assess the possible effects. For example, buying fewer or even no bonds at all from high-emitting companies could help redirecting funds to low-carbon activities. But it could also hinder transition away from carbon if it takes funding away from large polluters that have made firm and near-term investment plans to reduce their carbon footprint. So here we think careful analysis is just very important. Well, that's quite interesting. It's actually not as black and white as it might seem that you just stopped buying bonds from these polluters because actually that might stop them from making the progress that we want them to make in the near term, right? Yes, indeed. Now another aspect that we hear a lot about in discussions on this topic is transparency. And the Vice President just mentioned that while we know for sure that climate change has an impact on the financial sector, the exact risks aren't necessarily that clear. That's right, Irene and I. Yes, exactly. And it's also important in the context of monetary policy. So this is the third aspect of the action plan I want to touch on. It relates to the much needed transparency in the field of climate change data. And we also want to practice what we preach. So in this regard, we have decided to start publishing climate-related information on our corporate asset purchases as of 2023 and as well as for our non-monetary policy portfolios. So these three actions I just mentioned and also the stress tests, the three stress tests are part of a broader climate agenda of the ECB. And I can imagine that listeners might want to know more. So I would like to really like to refer you to the information on the website of the ECB. Absolutely. And we'll definitely link to that in the show notes as well. Well, it certainly sounds like you're going to be busy getting work underway. And before we wrap up and I let you get on with said work, we always ask our guests for a hot tip about today's topic of climate change and climate risk. I think for this one, I really would like to share the story behind the picture. I have hanging behind me on the wall here in my home office. It's quite large and it shows the ocean and the horizon. And in the middle of the picture, in the middle of the ocean, there's one lonely mangrove tree with green leaves and its roots are standing out a bit above the water. This tree used to stand on the beach. The picture was taken on the other side of the road in Fiji where the shorelines are already heavily eroded due to rising sea level. It was taken by Kedir von Lohausen. He's a great photographer who traveled to places around the globe to capture with his camera the impact that rising sea level is already having today. And the forecast, you know, it's not looking good. A report published by the World Bank last week concluded that climate change could force 260 million people to move within their countries by 2015. And hotspots of internal climate migration could emerge as early as 2030. So the reason I have put up this picture in my home office is to remind myself just every day that even though the wildfires that were raging over Europe last summer are extinguished, the flooded areas dried up. But we should not lose sight of the urgency to act now and prevent as much as possible that the impact of climate change is getting worse. This also brings me back to the topic of today. The results of the economy-wide stress test that were published. They show that climate change impacts us all, including the economy, be it companies or banks, and we have to act now. Well, Irina, I can see this picture. This is an audio-only podcast, but we're lucky that we can see each other as well. And it's a beautiful shop, but I would call it tragically beautiful. And sadly, it's all too easy to forget what's actually happening as a result of climate change unless we have it in front of our eyes. So I think having a picture like that in front of you is very useful. And thank you so much for being on the podcast and giving us an insight into the work of the Climate Change Centre. And I look forward to speaking again when the work is up and running. Thanks so much. It was a pleasure to be here. This brings us to the end of this episode. Check out the show notes for further reading on this topic. You've been listening to the ECB podcast with Katie Ranger. If you like what you've heard, please subscribe and leave us a review. We'd love to hear from you, so do share your feedback and ideas with us via social media. Until next time, thanks for listening.