Joint efforts by the European Central Bank and European Systemic Risk Board have focused on curating a growing set of climate risk approaches into a structured surveillance framework, while outlining macroprudential policy options to tackle risks to financial stability. Tracking such risks rests on four building blocks – climate shocks, exposures, financial risks and channels of systemic amplification.

Climate shocks

As global temperatures continue their inexorable rise, climate shocks are looming one way or another: from unmitigated physical risks or transition risks to avoid them.

Physical risks include both acute events, such as floods and wildfires, which are already increasing in frequency and chronic phenomena, such as steadily rising sea levels. As global temperatures continue to climb, these shocks are set to compound.

Transition risks, by contrast, stem from the shift towards a lower-carbon economy. While this transition aims to reduce future physical risks, it can introduce short-term disruption. Policies need to be finely calibrated as sudden policy changes, disruptive technological shifts or abrupt market repricing of assets could catch financial institutions off guard.

Transition and physical risks are not independent – shock interaction is not only possible but likely.

Economic and financial exposures

The potential for these shocks to reverberate rests on the material exposures of both the real economy and the financial system.

In the euro area, banks remain the primary custodians of transition risks within the 20 economies – with loan books and investment portfolios tilted towards high-emission firms, households and economic sectors alike. Risk mitigation measures, in this respect, are key – requiring banks to manage the exposures of their counterparties.

In contrast, for physical risks, it is insurance companies and government balance sheets that are particularly vulnerable – noting the strongly underinsured nature of climate risks. In this context, adaptation measures – including expanding and completing insurance markets – are essential to bolster resilience.

From exposure to financial risk

While exposures create fertile ground for climate shocks to impact financial systems, they are only necessary, and not sufficient, conditions for financial loss. The extent of losses depends on how climate shocks interact with a function of existing financial vulnerabilities.

Unfortunately, historical data offer little guidance here, posing a significant modelling challenge. Given the inherent uncertainty and potential for multimodal outcomes, scenario analysis becomes essential. It can, in particular, help illustrate how factors such as credit and market risk could materialise under different risk constellations.

Channels of financial amplification

In an ideal scenario, sporadic shocks would lead to isolated, unrelated financial losses at the firm or institutional level. However, as global temperatures rise across vast regions, the likelihood of pervasive shocks increases, raising the risk of systemic financial instability. Amplification mechanisms, such as contagion and spillovers, could transform localised shocks into undiversifiable risks.

One source of amplification could be compound shocks – or the degree to which climate shocks come atop an already challenging economic environment, such as a recession. Additionally, climate shocks themselves may reach tipping points – whereby breaching certain temperature thresholds triggers accelerated and unpredictable climate outcomes such as large-scale melting of ice sheets or permafrost.

Financial contagion, meanwhile, could arise from both the side of climate and financial dynamics. Climate shocks might spread across borders through the integrated supply chains that characterise regional and global trade. On the financial side, history shows that crises often force financial institutions to sell off assets to raise funds, leading to potential spirals of falling asset prices and spreading losses across overlapping portfolios.

Lastly, spillovers take multiple forms, but perhaps the most concerning would involve risk transfer across institutional sectors – particularly from the private to the public sector. Governments might be compelled to intervene, bailing out underinsured institutions or industries. The result? In certain conditions, climate risks might not be just a private sector problem – but risk morphing into a full-blown public sector crisis.

An eventual macroprudential playbook

What can be done to ensure that the financial system is resilient to systemic risks emanating from climate? Macroprudential policy is key.

By its very nature, systemic risk is all-encompassing, and so too must be the scope of a macroprudential policy playbook. Three areas warrant attention, drawing on the existing toolbox.

First, policy-makers can pursue multiple paths to bolster banking sector resilience. Depending on their objective, they main aim reduce overall balance sheet risk or target high-risk exposures that could amplify or propagate contagion. Candidate instruments already in the macroprudential toolkit include capital surcharges — either general, or tailored to specific or portfolios— and exposure thresholds to limit contagion from large exposures or systemically important institutions.

Second, borrower-based measures, such as loan-to-value or debt service to income limits, can complement these bank-based efforts by curbing the build-up of systemic risk.

Third, looking at the broader financial system, improving both information and insurance needs to remain in primary focus. Enhanced transparency can mitigate the scope for informational market failures, enabling markets to more efficiently and effectively allocate risk. At the same time, addressing the insurance protection gap would tackle the potential for spillovers, equipping financial markets and financial institutions to better handle risks that remain underinsured – even in developed markets like those in Europe.

Of course, implementation needs to be handled carefully. As the saying goes, the devil lies in the detail and striking the right balance is key. Delaying action risks exacerbating future consequences while premature measures based on incomplete information could be misplaced. It also risks disrupting transition finance and hinders necessary flows to industries undergoing green transitions. A gradual, scalable approach appears the most prudent course of action. This would allow regulators to adapt policies based on emerging insights, while fine-tuning measures as the financial stability dimensions of climate risk become clearer.

This article draws on insights from the European Central Bank and European Systemic Risk Board report, ‘Towards macroprudential frameworks for managing climate risk’ (2023).