The European Union is starting to prepare the region’s next stress test to measure the financial sector’s readiness for climate change, with the exercise set to involve the insurance industry for the first time.
The European Commission last week asked the relevant agencies to begin preparing the exercise, according to documents on the website of the EU’s insurance regulator EIOPA. The test, to be published by the first quarter of 2025, follows on from a similar test in 2022 which pitted banks against scenarios that were much gentler than many in the industry had feared.
“We need to be aware of any potential vulnerabilities in the financial sector and of how stress in the financial system could affect the transition to the 2030 goals,” EU Director-General John Berrigan wrote in a letter to the heads of the relevant EU agencies, referring to the EU’s target of slashing greenhouse emissions by the end of the decade.
Berrigan asked the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority to prepare relevant scenarios for the test.
The inclusion of insurers marks an expansion of the region’s preparations for the transition of the financial sector. Insured losses from climate change hit about $120 billion in 2022, according to data compiled by Munich Re, and the industry is generally seen as at risk of rapidly-rising losses from weather and climate-related events.
Last year, banks participating had to estimate how events such as floods would impact mortgage values, or how big a hit they faced if corporate clients defaulted after a spike in carbon prices.
The Commission gave some details on the scenarios included in the next incarnation, telling the agencies to come up with “severe but plausible” ones for the entire period until 2030. It said one scenario should focus on “near-term” risk that would occur as asset price correction. Another scenario could combine climate-change risks with those seen in classic financial stress testing, and there would also be an “adverse scenario.”
In the previous installment in 2022, banks generally stayed above their regulatory capital levels even in the test’s most adverse scenario. Most of the participating banks and the European Central Bank, which oversaw the test, later labeled it as a useful learning exercise.
The ECB has publicly faulted banks for not having enough data or adequate models for calculating the risk they face from climate change.
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