Economy-wide climate stress test: methodology and results

In March 2021, the ECB published the preliminary results of the first economy-wide climate stress test to assess the exposure of euro area banks to future climate risks by analysing the resilience of their counterparties under various climate scenarios.

In this context, the ECB has published the final results of its wide climate stress test, which show that companies and banks benefit from adopting green policies in order to foster a transition to a sustainable, zero-emission economy.

Economy-wide climate stress test: methodology and results

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Executive summary

The objective of the ECB’s economy-wide climate stress test is to assess the resilience of non-financial corporations and euro area banks to transition and physical risk under climate policy scenarios. Within the analysis, three pillars and four distinct dimensions can be distinguished. The exercise reveals that an orderly and rapid transition minimizes costs and maximizes profits and offsets the short-term cost of transitioning to a zero-carbon economy, showing that companies and banks benefit from adopting green policies in order to boost zero-emission economy.

Main content

This Technical Note summarises the main aspects of the exercise:

• Methodological framework. The climate stress test provides a comprehensive methodology for assessing the impact of alternative scenarios that differ in their levels of transition risk and physical risk, over a 30-year time horizon. It is a top-down exercise, as it relies solely on internal datasets and models, and has been conducted centrally by ECB staff. On the other side, the ECB’s economy-wide climate stress test applies three main scenarios which differ from one another in their associated levels of transition risk and physical risk.
• Transmission to firms. The non-financial corporations have to cope with two main types of risk; transitional and physical, which will affect the probability of default and will make changes in leverage. Overall, the median European firm is less indebted, more profitable and has a lower probability of default at the end of the horizon under the orderly transition scenario as compared with the two adverse scenarios.
• Transmission to banks. The ECB climate stress test evaluates the impact of climate risk on the euro area banking system through the credit and market risk channels. Different climate scenarios are used in order to quantify the impact on banks’ credit risk, the changes in the PDs and LGDs of banks’ loan books.
• Conclusions. The early adoption of policies to drive the transition to a zero-carbon economy brings benefits in terms of investing in and rolling out more efficient technologies. The results show that when comparing the effects of transition and physical risks, the latter would be more important in the long run, especially if transition policies towards a more sustainable economy are not introduced. The results also show that impact on banks’ expected losses is mostly driven by physical risk and is potentially severe. Finally, if climate risks are not mitigated, the costs to companies arising from extreme weather events could rise substantially, and greatly increase their probability of default.

Download the technical note by click​ing here (technical note only available in English).