Climate stress testing the European economy: is the European Central Bank up to the challenge?

Written by Professors Aurélien Acquier and Jérôme Creel – ESCP Business School.

Professors Aurélien Acquier and Jérôme Creel analyse the results of the ECB’s first climate stress test on non-financial companies and banks in the euro area. However useful and commendable such a test may be, it does not really seem to have grasped the scale and the true nature of the risks that climate change will pose to the economy and our businesses.

A few weeks before the COP26 opening, the European Central Bank (ECB) published the results of its climate stress test, which examines how resilient Europe’s companies and banks would be to climate change between now and 2050, and contributes to the recognition that climate is a major systemic risk.

Instead of taking banks’ own assessments of climate risk as its starting point, the ECB adopted a more innovative approach by starting from companies’ balance sheet data, creating an impressive database of more than 4 million businesses and 1,600 banks in Europe. Until now, climate stress tests only dealt with “transition risks”, i.e. the economic costs of economic policies aimed at “decarbonising” the economy.

In this framework, the economic risk was only considered through the financial losses of industries heavily dependent on fossil fuels (automotive and oil industries). These initial tests ignored the environmental risks linked to climatic catastrophes (floods, droughts, loss of agricultural productivity, etc.). The ECB study corrects this myopia: alongside the “transition risks”, it includes the existence of “physical risks”, i.e. the financial damage caused by climate disasters, which are set to increase drastically in the absence of significant action on the climate front.

Failure to take strong action on global warming could reduce Europe’s GDP by 10% by 2100

What is nevertheless interesting is the gap between the ECB’s serious speech and the concrete and quantified content of the study. Indeed, if no climate policy were implemented a median European firm would see its profitability fall by 40% by 2050, and become 6% more likely to default during the same period, compared with a scenario in which the targets set out in the Paris Agreement are adhered to. Without strong measures, Europe’s GDP could be 10% lower in 2100 than in an “orderly transition” scenario.

The precise content of the study suggests a serious underestimation of the impacts of climate change on European economies, linked to some questionable assumptions by the Network for Greening the Financial System (NGFS) on which the BCE relied.
The report throws up a whole host of questions and reservations. The first of these relate to whether the scenarios used by the ECB are realistic. As desirable as it may be, can we in all seriousness assume the baseline scenario to be that of an orderly transition in line with the Paris Agreement? This scenario is based on a drastic, continuous and common global reduction trajectory for all CO2 emissions, in order to keep warming well below 1.5 degrees above pre-industrial levels between now and the end of the century. Here, it is necessary to recall that 1) the current national commitments and trajectories taken by countries following the 2015 Paris agreements and COP 26 lead de facto to a warming trajectory of around 3 degrees and 2) no European country is currently meeting its own commitments. Let’s be clear: the ECB’s ‘baseline’ scenario would require nothing less than a global institutional and political revolution – the only way we will be able to radically change our energy usage and the associated CO2 emissions.

Secondly, it is surprising to see what little impact such radical climate choices would have on the economy’s trajectory: according to the study, there appears the GDP can continue to grow indefinitely and follow trajectories that are ultimately very similar, regardless of the climate policy implemented. At just 10% over an 80-year horizon and just 0.14% in annual GDP, the difference in GDP in 2100 between the orderly transition scenario and the extreme “hot house world” scenario is anything but extreme!

As a reminder, more than 15 years ago, the Stern report stated there was a risk of losing between 5 and 20% of gross world product every year, a figure that Nicholas Stern himself retracted several years later, believing that it had been underestimated…

Furthermore, by assuming continuous GDP growth (between 1.32% and 1.17% per year depending on the scenario), the ECB considers that it is possible to decouple GDP growth from fossil energy use. The problem is that, when it comes to global economies, removing this link seems like a distant dream as fossil fuels still account for 80% of the world’s energy mix.

Has the ECB read the IPCC reports?

We may well ask whether the ECB has fully grasped the risks posed by climate change and the challenges that come with it. When we consider that the latest report by the Intergovernmental Panel on Climate Change (IPCC) states that our societies should drastically reduce their greenhouse gas emissions to avoid an unmanageable risk
a continued uncontrolled rise in emissions would result in average temperatures increasing by between 1.9 and 3 degrees between 2040 and 2060. The ECB appears to have seriously underestimated the climate risk associated with such a scenario. One degree more in 30 years represents nothing less than a drastic leap into the unknown, all the more so given that climate risks can be non-linear and punctuated by threshold effects in certain regions.

“The very idea of economic growth risks becoming quite conceptual.”

If we are to truly take on board the work done by the IPCC (Intergovernmental Panel on Climate Change) scientific community, our businesses must reduce their greenhouse gas emissions drastically in order to achieve carbon neutrality and avoid a situation that is impossible to manage. Without strong and global action, it is, for example, the production capacity of our agricultural systems that is at stake. If we fail to remain on a trajectory that is in principle controllable, then the very idea of economic growth risks becoming quite conceptual, and we can ask whether putting figures on these impacts in terms of GDP really means anything.

While the succession of COPs reveals the tragic gap between speeches, commitments and actions, the ECB’s climate stress test reveals another form of decoupling: within the same study, it is possible to dissociate a discourse that says A and a technical content that says B. In seeking to be reassuring, the ECB could end up hindering the efforts of European businesses to take the risks of climate change seriously. Nevertheless, this initial climate stress test is without a doubt an important first step in that it distinguishes the short-medium term risks (transition) from long-term ones, and helps to assess the costs that European businesses could face if there is a delay in getting to grips with the challenge of climate change. However, it appears to seriously underestimate the scale, as well as the systemic and uncertain nature, of the climate risk to our companies and economies. The next step will be all the more useful as it will include more varied economic scenarios and will incorporate our knowledge of climate physics based on the research done by the scientific community, something that is outside the scope of economics but just as crucial to its goal.

The authors would like to thank Christophe Cassou (senior researcher at the French National Centre for Scientific Research (CNRS) and co-author of the latest IPCC report) for editing and contributing to this article.


Image credit: Epizentrum, CC BY-SA 3.0, via Wikimedia Commons

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Lisa Baker is the Editor of Always Finance, and writes about Business, Finance Technology and Healthcare. Lisa is also the owner of Need to See IT Publishing.