 You're listening to the ECB podcast bringing you insights into the world of economics and central banking. My name is Katie Ranger. Climate change is one of the many challenges facing our planet and our livelihoods, but it's also a pressing issue for central banks. Here at the ECB, we've done a lot to acknowledge that in recent years. There's already a lot of work going on in different parts of the bank and just recently we added to it with new action. Our discussion today will focus on two big milestones. First of all, the results of our very first stress test on climate related risks for euro area banks. And second, our recent announcement on incorporating climate change into our monetary policy operations. For that, I'm welcoming Frank Eldersen back to the podcast. He's a member of our executive board and vice chair of our supervisory board. Frank, great to see you again for what is now, I believe, your fourth appearance on the podcast. Well, thank you so much, Katie. It's a pleasure to be here. Now, over the past two years, we've really been pushing banks to improve how they manage and disclose climate and environmental risks. And we've just reached another milestone on that journey, the very first climate stress test looking specifically at banks. For the first time, we focused on risks posed by climate change. So that's physical risks, things like floods and droughts, but also transition risks. So risks that can emerge as our economy moves towards being less polluting and greener. Now this stress test was a special one too, because it looked at a very wide range of aspects, things like how prepared banks are to manage these risks, as well as a couple of other things that we'll talk about too. Frank, let's first talk about what exactly the stress test looked at. Can you walk us through that? Sure. So first of all, it's important to say that the test was very much a learning exercise for banks and for us as supervisors. It wasn't what we call a capital adequacy exercise to see whether banks have enough capital to withstand climate risks, as you would usually expect from a stress test. We collected numbers, yes, but we also collected more qualitative information. So when we say that, we mean everything that isn't the numbers. But that still plays a very important role in determining how prepared banks are to manage climate related risks, things like processes, best practices, even mindsets and levels of awareness. So you might want to know, so how did we do this? So we looked at 41 of the largest banks across the euro area and we assessed how they would fare in different scenarios and over several time horizons. So the exercise evaluates aspects of both physical and transition risk, as you just explained. And in terms of physical risks, our assessment focused on two extreme weather events. So a major flood and a severe drought over a one year time horizon. And then in terms of transition risk, in the test, we looked at short and long term vulnerabilities and strategies in the phase of several scenarios. So that sounds all very abstract. But let me explain. So in terms of the short term vulnerabilities, we looked at a three year disorderly transition scenario. And that actually means that what we looked at is what would happen if there were to be a sharp increase in the price of carbon emissions. That's what this disorderly means, right? Exactly. That it's not really done in an orderly or an organized way, shall we say? Exactly. So, you know, kind of like in terms of a surprise, suddenly that price of carbon goes up. So that's what we put in that scenario. And then in terms of the longer term strategies, we looked at various transition scenarios spanning a 30 year horizon. So much longer. Much longer. The exercise considers the impact of transition risk from a credit, a market, an operational and a reputational risk perspective. And we looked at qualitative, so non-number perspectives. And, you know, all in all, stress testing is really a great tool and a big step forward for us as a supervisor and also for the banks. Okay. So lots of different scenarios and time horizons because, well, essentially we don't know how the transition will be. I mean, we obviously hope there will be an orderly one, but we just don't know. Exactly. And that is new. We have not done that before. And again, we played a little bit with physical versus transition risks, one year scenario, three year scenarios, 30 year scenarios, to indeed try to get a grasp on what that uncertain future might entail. Now, it's not the first time that we've talked about climate change on the podcast, and we've actually also talked about how climate change can affect banks. Of course, we'll link to those previous episodes in the show notes, but I do think it's worth just briefly recapping with an example of what exactly happens. So banks give out, they grant loans to people and companies. And some of those people and companies that receive the loans are exposed to risks coming from climate change. Now, that can be floods, droughts, but it can also be that they're not just not prepared for a world, a greener world. Their business isn't prepared for it. Now, because of the impact of those risks on the people and the companies, it might be the case that they can't pay back the loans that the bank has given them. Well, what does that mean for the banks? Well, it means that they might make a loss on those loans. So it's very clear that banks need to have a better understanding of these climate-related risks so that they can manage them accordingly. And indeed, that's why stress testing is just so important here. Now, Frank, can you tell us what you found in the stress test? You said what you looked at, but what exactly were the findings? How prepared are banks for well, for what's coming our way? Sure. So on the stress test, it confirms that banks must sharpen their focus on climate risk. So let me start with the physical risk. So the impact varies across the banks. Whether banks are vulnerable to droughts highly depends on where they and the business that they are exposed to are located. And this is rather intuitive, isn't it? Yeah. The risk for banks rises as, for example, agriculture and construction activities decrease. And these are two sectors very much affected by weather extremes, as you can imagine. If big construction projects are put on hold, for example, because of extreme heat, this means losses for the banks, which have financed them. And similarly, in a flood risk scenario, it is mostly real estate collateral on mortgages and corporate loans that is expected to suffer in geographical locations at risk of flooding. Okay. So it's got a lot to do with geography, with geographical locations. Although I do have to say we are seeing a lot of hot weather all the way across Europe at the moment, not just in, shall we call them the traditional areas, which I suppose kind of highlights just how urgent this is. What about transition risk? What did you find there? Okay. So in terms of transition risks, the results of the stress test show that an orderly green transition translates into lower losses than a disorderly transition or no policy action at all. Also kind of intuitive. Certainly. Banks show little differentiation between long-term scenarios as they appear to have insufficiently detailed strategies, other than the tendency to reduce exposures from the most polluting sectors and supporting less carbon emitting businesses. Banks' climate risk-related credit and market risk modeling overall remains at an early stage of development. Okay. So they're just not looking at it in enough detail yet? Exactly. And they don't translate these possible futures into their strategy. And if they do, they don't differentiate between these various scenarios and we are convinced that they need to do so in order to manage the related risks appropriately. Now, I said earlier, this is a learning exercise and I said this is not the typical number crunching only kind of stress test. We also looked at the qualitative aspects. But in terms of a number, so if you want to put a number on all this, I can say that the stress test shows that in our scenarios, the 41 banks that we looked at would suffer 70 billion euro of losses. So quite a big number. Yes. But this understates the actual climate risk significantly. And there are a number of reasons why that is the case. So first, we only have a limited amount of data available at this stage. And second, the modeling that the banks use in their projections only captures climate factors in a rudimentary way. So it's not developed enough? No, exactly. Three, we excluded from our scenarios a general economic downturns. And the fourth reason why this number understates the risk is that we only looked about one third of the banks' exposures in this exercise. And then, and this is a little bit more technical, normally what we would do in a stress test is we get the numbers from the banks and then we would look at them very critically and apply what we would call supervisory overlays. And this time we didn't because this was a learning exercise. And then again, we in the end only looked at 41 banks in the number crunching part of this exercise. So again, maybe a little long list and maybe a little technical, but it shows that the 70 billion that we found is, again, most likely a significant understatement. Now, this was not just about the numbers. The learning part is crucial. And I've said this many times before in many speeches and in other occasions, but I will say it again. Banks must take decisive action to address their shortcomings and to prepare for the transition to a carbon neutral economy. And I'm convinced that the findings will serve as a compass for them to do just that. Now, we've already mentioned the very broad scope of this climate stress test. And in addition to the stress test itself that you've just described, Frank, we also looked at what our supervisors call climate stress testing capabilities. Quite a difficult phrase to say there. What was this part of the exercise all about? So here we looked at 104 banks in Europe and we assessed how well they are set up to deal with climate related risks. So remember that this is all still relatively new terrain for many banks. So the question that we asked was, are you able to measure and assess risk posed by climate change? And this covers looking at how climate risk affects different banks' businesses and how we look at what we call climate risk transmission channels. For example, market and credit risks and corporate or market portfolios. And we did that comparing banks against a common set of climate risk metrics. Okay. So it's all about seeing how good banks are at assessing the risk they're exposed to from climate change on an ongoing basis, essentially stress testing themselves, right? Exactly. And learning how to stress test. So in the future we will do more of these. And so it's very important not only that the banks do this first stress test and then we look at what is the outcome of it. But I would say right now it's even more important that we just learn together how to do this, how to use this new tool so that in the future we can do it in an even more sophisticated, effective manner. Okay. And what did you find in terms of their climate stress testing capabilities? So here we found that 60 percent, so more than half of the participating banks, do not yet have a climate risk stress testing framework in place. And in addition, most banks do not consider climate risk in their credit risk pricing or in their risk management models at all. And only one in five banks, so just 20 percent, consider climate risk when granting loans. Those are pretty worrying findings, I'd say. Yes, they are. And that's why we say that banks need to seriously step up their game in sharpening their focus on climate risk by having their own stress test framework in place. And otherwise they are operating in the dark when it comes to these risks. Absolutely. Now in the last part of this stress test exercise, you looked at banks' balance sheet. So in other words, who are banks giving loans to and how prepared are these parties for the upcoming transition? What's the picture like here? Now what we found here maybe doesn't come so much as a surprise. Banks generally still rely a lot on carbon-emitting sectors. Almost two-thirds of their income from business customers comes from greenhouse gas-intensive industries. And in many cases, these come from a small number of very big companies. And this of course increases the bank's exposure to transition risk a lot. So the risk is quite concentrated there. That's the term. And another finding is how much or better how little banks know about their customers' carbon footprint or transition plans. So we found that banks really heavily rely on what we call proxies to estimate their exposures to emission-intensive sectors. And that makes them vulnerable to transition risks. While proxies are a good first step to close data gaps, banks need to improve what we would call the robustness of these proxies. So they need to step up engagement with their customers and to directly collect relevant data from their customers. Okay, so not just rely on kind of third-party information but really get in there and ask their customers exactly what's going on. Exactly. Now data availability, because that's actually what we are talking about here, is a tricky terrain. And no doubt. But some banks, and that is actually the good news, are already on the right track. So some banks managed to collect direct data from their counterparties, from their customers, for at least 90% of their reported income. And other banks managed to build reliable proxies based on actual data from their customers. So we have found good practices. And this shows that it can be done. And this I think is actually a very important message. Maybe the number of examples that we found where there is indeed already today good practices is not so big. But the fact that they are there already today means that what we are asking is not beyond the possible. It is actually being done already. Okay, so there are a couple of positives that we've talked about. But if I reflect on our discussion so far, I have to say it does paint a kind of gloomy picture. And it seems that generally the banking sector just isn't well prepared at all for the climate crisis. As I said, there are some good practices. But indeed, we expect banks to take action on various fronts. For example, to develop robust climate stress testing frameworks. And to be clear, this needs to happen now. But it isn't all bad. More and more banks are increasing their awareness of the impact climate change can have on their balance sheet and on their long term strategies. And although there isn't a single bank that does it all, that would of course be wonderful. We do see an increasing number of banks that have made good progress. So there are best practices out there. And this is a key aspect. We are currently collecting and planning to share best practices towards the end of this year. And together with individual feedback that each bank will receive from this exercise, we then expect them to put these best practices into action. You've said a few times that it's also a learning exercise for us as supervisors. So what's next for us? What will we do with all these findings? And how will that feed into our supervisory activities? This year, stress test results will feed into our annual supervisory process, only qualitatively. So when I say that what we mean is that when we assess the day-to-day practices and procedures, the mindset and the level of awareness in banks when it comes to climate risk, that's what I mean with qualitatively. So for now, there is no concrete impact on banks' capital requirement. But this is of course no excuse. Let me just underline this. This is no excuse to avoid progress. All I can say is that the bar will be raised over the coming years. And this exercise serves as a compass for banks to make progress. Now, the results will also work hand in hand with other supervisory activities. For example, this year's thematic review of how banks incorporate climate-related and environmental risks into their businesses. So we will make sure to improve further the methodology that we have used. And we will reflect on how to design bottom-up stress test scenarios to make them as accurate and as relevant as possible. So more to come on the supervisory front after this milestone and sounds like we'll definitely be raising the bar over the next few years. Now I'd like to turn to look at the other side of our house, if you will, at monetary policy. Pretty much exactly one year ago, we published our climate action plan as one of the key results of our strategy review. And in fact, earlier this week, we announced further steps towards greening our monetary policy operations. And that was really a big milestone for us as a central bank. Now, contrary to what we do on the banking supervision side, so making sure it's the banks who manage their climate risk appropriately and that they're prepared for what's to come, this step on the monetary policy side was all about what we do when we define and implement monetary policy for the euro area. Like the stress test, it was also a big package covering lots of different aspects. And listeners, if you do want to go into the details, we will be putting a link to the press release in the show notes. But today I'll focus on two of those measures. First of all, the greening of our corporate bond holdings. And second of all, the changes to what we call our collateral framework. These are really both measures that go to the core of what we do in terms of monetary policy. So Frank, let's start with the greening of our corporate bond holdings. Now it is just worth mentioning where we're coming from. So our corporate bond portfolios have so far had what we call a carbon intensive bias. Now, what does that mean? Well, it means that those portfolios had a bias towards firms in carbon intensive industries. So think big polluters. Now, this is because they're guided by a principle called market neutrality. And as such, they replicate the market average. Frank, what does it mean when we say that we want to move from being market neutral to carbon neutral? Can you just break that down a bit for us? Let me start with the big picture. We want to achieve three things with our decisions. One, we want to reduce financial risk related to climate change in our own balance sheet. The balance sheet of the European Central Bank. And two, we want to encourage transparency. And the third thing that we want to achieve is to support the green transition of the economy in line with the European Union's climate neutrality objectives. So these are all the kind of things underpinning or driving our decisions? Exactly. So one of the measures is that we have decided to start, as you just explained, greening our corporate bond holdings. And this will be done step by step. We want to gradually decarbonize them on a path that is aligned with the Paris Agreement goals as laid down in the EU's climate neutrality objectives. Okay. So decarbonize sounds like we're moving away from these very carbon intensive firms. Exactly. Exactly. So the total amount of bonds will stay the same as we have already stopped buying corporate bonds, but we do reinvest those that are maturing. And this gives us the opportunity to tilt our purchases towards issuers with better climate performance. So tilting is the word here and it means that the share of our assets issued by greener companies will be increased compared to companies with a lower climate performance. So how exactly will you go about this? I'm kind of curious to know how on earth you would know where to tilt to. Right. So we look at the firms that issued these bonds that we buy or in this case we reinvest in. And looking at these firms we look at their past greenhouse gas emissions, their climate related disclosures. Okay. So what they say about their own operations? Exactly. And this is also very important, their future decarbonization commitments. So we look to the past, we look to the future and we look to how they actually disclose. Okay. Got it. That's clear. But can I ask a somewhat blunt question? I mean it's all well and good that we're greening some of our operations, but ultimately it's governments who are the ones in the driving seat when it comes to policies to fight climate change, right? But where exactly did we come into this whole picture as a central bank? Excellent question. I'm glad you asked it because this comes up all the time and it's important that we give a clear answer to that. So indeed governments are climate policy makers and we are actually only climate policy takers. Now this having been said, addressing climate change is a global challenge and we have a strong interest in helping tackle it for several reasons that go straight to our mandate as a central bank. So our job is to keep prices stable and climate change affects how the prices of things change through its impact on the economy. And in our pursuit of this objective, we can do something to support the green transition of our economy and climate change poses a risk for our financial and banking systems and its impacts could badly damage the economy. And then there's a third element here, tackling climate change is a priority for the European Union. And on the basis of what we call our secondary objective, we have an obligation to support the general economic policies in the union as long as that does not prejudice our price stability objective. Okay, so there are lots of reasons why we also need to be part of this fight as a central bank. Exactly. Now focusing a little bit more specifically on tilting, tilting has two objectives. It aims to mitigate climate related financial risk of our own central bank balance sheet and it incentivizes issuers. So in this case, the companies, the firms to become better at disclosing their climate risks as well as reducing their carbon emissions in the future. So with our corporate bond purchases, we are actually one of the biggest players in that market. So our actions will indeed have an effect. We expect to start with this from October 2022. So this year, and we will publish more details closely before actually starting doing this in October. And I just talked a little bit about the disclosures and that's another part. It is important that we walk the talk. So we will also start publishing climate related information of our corporate bond holdings regularly as of the first quarter in 2023. Okay, so now you've decided on this important package and it's going to get underway in October. Is that the end of the story? No, it's not. We are also explicitly committing to reviewing our measures and reviewing constantly their impact with a view to changing them if they don't have the intended effect. So this package we just agreed on, it's important, but it's not the end of the story. So it's not the end of the story, but as you've explained, Frankie, it is all within our mandate. Exactly. So this is a big milestone for us, but it is indeed important to mention again that the ECB is not a legislator. We cannot set climate policies and our measures always need to be justified by our mandate. And again, we are dependent on governments to take action on climate policies. And then we translate that into what is our own remit. Okay, the last thing I'd like to ask you has to do with us lending money to banks. So kind of goes back to the banks that we started the episode with. Now, this is how we as a central bank create money. When banks borrow money from us, they do so against a certain amount of collateral. What's that? Well, in other words, it's a security for a case that the bank cannot pay back their loan. We've also decided something there when it comes to tackling climate change, right? Exactly. So what we have decided is to limit the share of assets linked to high carbon companies that can be pledged as collateral when banks borrow from us. So in the future, we will only accept assets issued by companies that are compliant with the EU rules for sustainability reporting once these are implemented. And this requirement will apply to all companies that fall within the scope of these rules. So taken together, these measures aim at reducing climate related financial risks in our own balance sheet. And ultimately, this may help to steer financial flows towards supporting the green transition. Well, this all sounds very, very promising, Frank. And as I've mentioned, the package is broader than just the corporate bonds and the collateral measures. So if you do want to read more about it, check out the links in the show notes. Now, Frank, before we wrap up, as you know very well, we always have a question that we ask our guests on the podcast. And that is for a hot tip linked to the topic we're discussing today. Now, I have to say you set the bar quite high in previous episodes with your hot tips. What do you have for us this time? Well, thank you. Thank you, Katie. And this is always one of the most fun parts of this conversation. I was thinking, you know, it's the beginning of July. So many of us will take some time off in the months to come. And, you know, we might travel to places that we love, that we think are exceptionally beautiful, that have memories when we were small and when they're maybe with our parents and brothers and sisters. Now, if you were to revisit such places in the mountains, on the shores of our wonderful continent, in the forest, wherever you really think this is beautiful, think about it in 2050. How will that look like? How will your children and grandchildren, you know, be there at that place which is so special for you? And that might be, you know, a strong reminder for all of us how important it is to solve this issue of climate change. Thank you so much, Frank, for joining the conversation today. Thank you, Katie. Well, that brings us to the end of this episode. I want to thank Frank Elderson, member of the ECB's executive board and supervisory board vice chair for breaking down this topic for us. Check out the show notes for further reading. 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. Until next time, thanks for listening.