SPI Journal, Winter 2023
Carbonomics: the path to net zero

Reducing emissions reduces banking losses

Banks need to get to grips with their clients’ carbon footprints, explain Marco Belloni, assistant vice president, Swiss Re, Friderike Kuik, economist, and Luca Mingarelli, financial stability expert, European Central Bank.

The adverse effects of climate change are becoming more prominent every year worldwide, with man-made emissions being one of the main causes of it. Meanwhile, in Europe, governments and policy-makers are trying to implement measures to mitigate climate change, in an attempt to foster a transition to low-carbon economies. These include the ‘fit for 55 package’, aimed at reducing the European Union’s net emissions by 55% by 2030 through an extension of the EU Emissions Trading System, a revision of energy taxation and setting targets for the implementation of renewable strategies.

If unprepared to transition or forced to transition abruptly to net zero, firms might suffer losses and decreased productivity following sharp increases in the price of fossil fuel energy, carbon taxes or shifts in consumer preferences to less polluting options. The consequential deterioration of firms’ finances and heightened default risk might in turn imply losses on the banking sector balance sheet. This could potentially weaken and destabilise the financial system, which may not be able to fulfil its role in providing necessary credit to the economy in a financially precarious environment. Crucially, such a scenario would further reduce the likelihood of a timely and cost-efficient green transition.

Even if firms’ emissions remain stable, sudden adjustments in climate policy stringency may pose significant tail risks for the banking system. Estimates published by the European Money and Finance Forum suggest that, in the worst cases, banking system losses might be substantial even with moderately ambitious policies (Figure 1). However, on average the losses will be relatively contained.

For example, a reduction in firm emissions by 30% and an increase in the effective cost of carbon born by firms of €150 per tonne would see tail losses increasing by 14% compared to the baseline. This reduction in emissions corresponds to average estimated emission reductions by 2025 compared to 2020 when pursuing policies to limit global warming to 1.5 degrees Celsius by 2100.

In the same scenario, firm emission reductions of 50% would imply tail losses only increase by around 7% compared to the baseline. With firm emission reductions of 50% and an increase in the effective cost of carbon born by firms of €100/t, average banking system losses are estimated to increase by just 1% compared to the baseline. This situation corresponds approximately to the estimated change in emissions and necessary five-year change in carbon price in 2035 compared to 2030, with policies limiting global warming to 2 degrees Celsius by 2100.

Banks should carefully assess lending to firms that are not following ambitious emission reduction strategies to avoid additional losses arising from a transition to a low-carbon economy. Banks’ knowledge of their clients’ carbon footprints and emission reduction strategies will be pivotal in coming years. Recent efforts on fostering climate disclosure made by central banks and other organisations will help the financial system in doing so.

Finally, prudential measures may also be necessary to prevent the build-up of banking system losses or pockets of risks through bank exposures to firms that are not able to adapt their business models to the new environment.

Figure 1. Increase in banking system losses declines with increase in firm emission reductions