17 June 2021

FT van Steenis: Investors should prepare for impact of green stress tests on banks

The world’s central banks are going green. At a recent “Green Swan” conference for regulators, the world’s top central bankers agreed they had a clear role to play in tackling climate change. But which measures are the most important? And how much would their actions shift the cost of capital for high and low carbon companies?

I suspect that climate stress tests may prove the most powerful tool to nudge the financial system. Over the coming year, a dozen central banks will run climate transition stress tests on banks, insurers and pension funds, following the Bank of England’s lead. They include the European Central Bank as well as authorities in Australia, Canada, Japan and Singapore.

These tests could be highly catalytic in repricing the cost of capital between companies. Investors will want to get ahead of these exercises. Stress tests have been the single most consequential change in financial regulation since the financial crisis. They set the pace for capital and operational planning for banks simulating crises as a way to protect against them. They were central to the banks’ resilience during the pandemic.

Will climate stress tests be as effective? Central bankers are not climate policymakers, but requiring data and scenario analysis is likely to change risk management practices to assess climate risk as a financial risk. That was the reason I recommended them to the Bank of England in 2019: to provide a road map for integrating climate metrics into risk and governance. We just got a sneak-peak of some of the implications in a recent exercise undertaken by the French central bank.

First, insurers were far more affected than banks. The exercise suggested that extreme weather could quintuple the cost of related insurance claims by 2050. According to the Banque de France, covering these losses would require premiums to increase by 130-200 per cent. The tests also raise the spectre of insurance gaps emerging as it becomes uneconomic to insure.

Another lesson is about managing the transition. Risks for banks were considered “moderate”. Depending on the scenario, tests suggest loan losses could treble by 2050, compared with the doubling during the pandemic. But given that just 10 per cent of their portfolios were in the most sensitive sectors overall losses might only increase by 25-33 per cent...

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