ECB’s climate factor blurs line between prudence and policy

 

Presented as a response to uncertainty, its design raises questions of whether it is also an allocative climate-policy tool.

The climate factor provides an additional buffer for the Eurosystem against “forward-looking climate transition-related uncertainties” that could cause repricing © Jasper 

The writer is the programme director of climate regulation and policies at the EDHEC Climate Institute

In May, the European Central Bank published two reports distilling good bank practices in climate and nature-related risk management and stress testing from its extensive supervisory work.

On June 15, it began applying a new “climate factor” to marketable assets issued by non-financial corporations and their affiliated entities when pledged as collateral in its lending operations. Barely six weeks later, it committed to extending the measure to corporate credit claims in the medium term.

The sequence invites a comparison between the advice the ECB has distilled for banks and the way it has incorporated climate risk into its own collateral operations.

The reports recommend identifying and quantifying risks under different plausible scenarios, tracing the channels through which climate shocks affect counterparties and translate into financial impacts and ultimately into probabilities of default and losses given default. They also acknowledge modelling challenges and data limitations, and the uncertainty surrounding both transition pathways and the future frequency and severity of physical hazards.

As Frank Elderson, vice-chair of the ECB’s supervisory board, stressed in May, “we simply cannot predict the exact level of transition and physical risks we will face”. He called instead for building resilience.

Uncertainty about forward-looking climate risks is also how the ECB motivates its new climate factor. Standard collateral haircuts protect the Eurosystem against losses if a counterparty defaults and collateral loses value before liquidation. The climate factor comes on top, providing an additional buffer against “forward-looking climate transition-related uncertainties” that could cause repricing during that period. (...)