Banking Transition Risk Report
The European Central Bank (ECB) releases a banking transition risk report, aiming to analyze the differences between the European banking industry transition plan and the EU’s climate transition path, and to quantify transition risks.
The ECB believes that banks provide financing for economic transition, leaving their balance sheets exposed to transition risks. How to identify, measure and manage transition risks and guide high-carbon emission industries to net-zero is an important task for the banking industry.
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Why Bank Faces Transition Risks
Banks provide financing such as loans to companies and incorporate these loans into the asset portfolio. During the net-zero transition process, some companies in energy-intensive industries may be affected by rising carbon prices, increases in stranded assets, and changes in consumer preferences, which will cause difficulties in their operating activities and increase the risk of loan defaults. These defaults can result in losses for banks. Therefore, the banking industry is generally faced with transition risks, and these risks need to be quantified in a timely manner.
Alignment assessment is an important tool for quantifying bank transition risks, and is usually used together with scenario analysis, stress testing, etc. When a company’s transition path deviates from the decarbonization path, the company’s adjustment of business activities will be slower than planned, and the possibility of default will increase. The alignment assessment uses the forward-looking data of the enterprise to measure the deviation of the enterprise’s transition path, and finally obtains the transition risks faced by the bank. In previous research, the ECB found that 32% of European banks have begun to use consistency assessment to measure transition risks.
In this study, the ECB uses the Paris Agreement Capital Transition Assessment (PACTA) provided by the Paris Agreement. PACTA compares changes to companies within banks’ credit portfolios with changes in those companies according to their decarbonization pathways and identifies 15 different technology scenarios for six transition sectors that account for 10% of total carbon emissions. 70% of the quantity.
The PACTA methodology has a five-year period to understand the extent of companies’ decarbonization transition. As part of its assessment, the ECB compares changes in companies’ future technology deployments with changes in decarbonization pathways. For example, a company needs to produce a certain amount of renewable energy every year under the decarbonization path, and the company’s actual investment within five years will also produce a certain amount of renewable energy. The difference between the two represents the difference in the company’s transition, and the difference increase transition risks. The transition risk faced by the bank is obtained by weighting all transition risks in a bank’s credit portfolio.
Transition Risks Faced by the Banking Industry
The European Central Bank analyzes the transition risks of 95 banks in the European region and finds that the credit portfolios currently held by banks are inconsistent with the warming goals of the Paris Agreement. The transition risks of 90% banks continue to rise. Transition risks mainly come from companies in the energy industry, which are slower to abandon high-carbon-emitting production and late to renewable energy production. In addition, 70% of banks have publicly committed to comply with the Paris Agreement, but their credit portfolios are still unable to meet the targets, leaving them exposed to litigation risks. Since 2021, there have been 560 climate litigation cases around the world, and the proportion involving companies and banks is increasing.
Since more than 60% of bank interest income comes from carbon-intensive industries, banks face great transition risks. The primary way to address these transition risks is to implement a transition plan that is realistic, transparent, and credible. Banks need to develop a transition plan from the current period to 2050 and identify key performance indicators to take timely action if the transition path shifts.
At present, consistency assessment has become an important tool for banks to manage transition risks. In the Capital Requirements Directive, the European Central Bank has required banks to develop prudential plans and asked supervisors to examine these plans to assess the transition risks faced by banks. In addition, the European Banking Authority has required banks to disclose the consistency of their credit portfolios with the goals of the Paris Agreement by the end of 2024 in the implementation of the Pillar 3 technical standard. In the future, banking industry transition risk management will become a common risk management category.
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