As advances are made by central banks – such as the Bank of England, ECB, and the Bank of Canada – to integrate climate-related risks into their financial stability assessments, estimating the implications for the financial system remains a work in progress.
Financial firms face extreme uncertainty in their plans to decarbonise their portfolios and assess the related balance-sheet impact. As strongly reiterated by the Intergovernmental Panel on Climate Change (IPCC) in its 6th Assessment Report, a failure to drastically reduce and, possibly, eliminate greenhouse gas (GHG) emissions by mid-century would lead to dramatically larger risks for humankind and life on our planet.1 At the same time, energy security concerns have been amplified by the war in Ukraine, posing the risk that a transition toward renewables might become more costly, complex, and disorderly (IMF 2022c).
This is likely to affect the decarbonisation plans of many countries that committed to more ambitious climate-emission reduction pledges in November 2021 at the COP26 conference: once the current crisis is overcome, the world might find itself having deviated further from the emission reduction path needed to meet the Paris Agreement goals. To make up for time lost and contain the risk of global temperatures exceeding 1.5°C above pre-industrial averages, decarbonisation ambitions will have to be scaled up. Those financial institutions that lack sufficient ambition in their decarbonisation plans at an early stage might find themselves wrongfooted when the urgency to reduce emissions regains momentum and leads to an accelerated transition away from carbon-intensive investments. This would materially increase their exposure to transition risk, one of the two main forms of climate-related risk (Löyttyniemi 2021).
As part of the IMF’s recent assessment of financial stability conditions in the UK,2 we have conducted an analysis of the risks for UK financial institutions stemming from an abrupt switch from a business-as-usual to an ambitious (but ‘orderly’) decarbonisation scenario, following the logic of the ‘climate Minsky moment’.3
The logic of the climate Minsky moment
Focusing on the domestic and foreign corporate exposure of banks, insurers, and pension funds, the exercise simulated the differentiated paths of gross value-added in different industries and countries until 2050, under the assumptions of a relatively ‘flat’ carbon price path (considered ‘business as usual’) and, alternatively, of a steeper and more aggressive transition scenario, drawing from the scenarios published by the Network for Greening the Financial System (NGFS 2021). The main idea behind the simulation was, first, that current climate-mitigation paths targeting the goal of net zero emissions by mid-century are not being factored into most asset valuations (as pointed out, for example, by Riedl 2021); and second, that perceptions about the likelihood of an ambitious decarbonisation scenario could change rapidly, leading to a widespread reassessment of market asset valuations. The trigger for such a shift in perceptions could be the outcome of some societal or political ‘tipping point’, like a mounting request for more decisive climate mitigation after a spell of more frequent climate-related extreme weather events. Or, the trigger could be electoral results in major countries that suddenly make the path towards net zero emissions more credible and irreversible. This, in turn, could become a turning point for asset valuations, leading to a collapse like that of Lehman Brothers during the global financial crisis (Steele 2020).
In our analysis, the differences between cash flows under the ‘business-as-usual’ and transition scenarios are discounted back to the nearer term to infer the impact on equity valuations (see Figure 1).4
Figure 1 Logic of the climate Minsky moment
Source: IMF staff.
The distribution of equity values across companies moves to the left because of the overall GDP reduction caused by increasing carbon prices, while dispersion increases due to the differentiated impact across industries and companies, depending on the carbon intensity of their products and production processes (see Figure 2, right panel).
Figure 2 Impact on asset valuations at the climate Minsky point
Source: IMF staff.
The changes in equity values are also transformed into changes in probabilities of default and credit spreads via a Merton-like model (Merton 1974).
Non-negligible transition risks
The exercise shows that, for banks, transition risks could translate into losses of the same order of magnitude as the results from the recent Bank of England solvency stress test and Climate Biennial Exploratory Scenario (CBES) exercises. Our exercise assumes a switch from a ‘National Determined Contributions’ scenario (with carbon prices slightly above $150/tonneCO2 by 2050) to an ‘orderly’ transition scenario like ‘Net Zero 2050’ (with carbon prices reaching almost $900/tonneCO2 by 2050). The eight largest UK banks would experience a loss rate of 3.6% on their corporate loan portfolios corresponding to credit losses of almost £79 billion.5 Including the market losses on their equity and corporate bond holdings, banks’ losses across all their corporate exposures could exceed £90 billion.
Similarly, for 14 large insurers the total market loss could amount to £66 billion, or 3.7% of investment assets. The impact could be as high as 11% on their equity portfolio, and 4% on their corporate bond holdings. For a sample of about 70 corporate occupational defined benefit pension schemes (representing one third of the segment in terms of total assets), the weighted average loss would reach approximately 3.5% of the portfolio value, with individual results ranging from -12.5% to 0%.
While the overall results do not indicate any imminent threats to financial stability, potential losses are non-negligible (also considering that they stem only from corporate exposures). The outcome would likely be even less benign under a scenario characterised by a ‘disorderly’ transition.6
The results from the Bank of England’s CBES, a dedicated scenario-based analysis of the transition and physical risks for banks and insurers, lead to similar conclusions.7
Our results inform the rapidly expanding field of scenario-based analyses of climate-related risks. Our exercise contributes some novel elements, like the specific characterisation of the ‘climate Minsky moment’ and the way it reconciles the very long-term horizons of climate-related risks with the typically shorter horizon of financial stability assessments.
Further progress in this type of scenario-based analysis is needed. This should aim to overcome the currently large margins of uncertainty in the simulations and to provide a clearer indication of the adequacy of financial firms’ resources to effectively mitigate risks stemming from the ongoing transition to a low-carbon economy.
Authors’ note: For a fuller account of the analysis, see IMF (2022b). The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.
Bank of England (2021), “Stress testing the UK banking system: 2021 Solvency Stress Test results”, 13 December.
Bank of England (2022), “Results of the 2021 Climate Biennial Exploratory Scenario (CBES)”, 24 May.
Carney, M (2016), “Resolving the climate paradox”, The Arthur Burns Memorial Lecture, 22 September.
IMF (2022a), “United Kingdom: Financial Sector Assessment Program-Financial System Stability Assessment”, 23 February.
IMF (2022b), “United Kingdom: Financial Sector Assessment Program-Systemic Stress, and Climate-Related Financial Risks: Implications for Balance Sheet Resilience”, 8 April.
IMF (2022c), “The Financial Stability Implications of the War in Ukraine”, Global Financial Stability Report, chapter 1, April.
IPCC (2021), “Summary for Policymakers”, 9 August.
Löyttyniemi, T (2021), “Integrating climate change into the financial stability framework”, VoxEU.org, 8 July.
Merton, R C (1974), "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates", Journal of Finance, May.
NGFS (2021), “Climate Scenarios for central banks and supervisors”, June.
Steele G S, “Confronting the ‘Climate Lehman Moment’: The Case for Macroprudential Climate Regulation”, Cornell Journal of Law and Public Policy 30(1).
Woods S, “Climate Capital”, speech to the Global Association of Risk Professionals, 24 May.
1 As stated in IPCC (2021), “[g]lobal warming of 1.5°C and 2°C will be exceeded during the 21st century unless deep reductions in CO2 and other greenhouse gas emissions occur in the coming decades” and “[p]rojected changes in extremes are larger in frequency and intensity with every additional increment of global warming”.
2 The IMF conducts periodic assessments as part of its Financial Sector Assessment Program (FSAP). For certain systemically important jurisdictions (like the UK), these assessments are expected to take place every five years. For the main report of the UK Financial System Stability Assessment 2022, see IMF (2022a).
3 As stated by Carney (2016), a climate Minsky moment represents “a wholesale reassessment of prospects, as climate-related risks are re-evaluated, [that] could destabilise markets, spark a pro-cyclical crystallization of losses and lead to a persistent tightening of financial conditions”.
4 For the largest firms the impact on cash flows is adjusted to incorporate the indications stemming from the Climate Credit Analytics© suite of models developed by Oliver Wyman and Standard & Poor’s (https://www.spglobal.com/marketintelligence/en/solutions/climate-credit-analytics).
5 For comparison, under the Bank of England’s 2021 solvency stress exercise, the same banks incur credit impairments (on all their loan portfolios, not only corporate) of more than £70 billion over 2021 and 2022 (Bank of England 2021); and the results of the CBES exercise point to between £95 and £100 billion cumulative (non-discounted) ‘extra’ impairment losses on bank lending to corporates from 2020 to 2050, depending on the scenario (Bank of England 2022).
6 Like, for example, the NGFS ‘Divergent Net Zero’ scenario (NGFS 2021).
7 “[B]ased on this exercise the costs of a transition to net zero look absorbable for banks and insurers, without a worrying direct impact on their solvency. By themselves, these are not the kinds of losses that would make me question the stability of the system, and they suggest that the financial sector has the capacity to support the economy through the transition” (Woods 2022).