The European Central Bank (ECB) has issued a warning regarding the significant transition risks faced by banks that are unprepared for the shift towards a low-carbon economy.

In a blog post coinciding with the release of a report titled 'Risks from Misalignment of Banks’ Financing with the EU Climate Objectives,' ECB board member Frank Elderson emphasizes the importance of banks identifying, measuring, and managing transition risks, akin to any other material risk.

Elderson highlights the global commitment made in Paris eight years ago to limit the increase in global temperatures to below two degrees Celsius. However, recent scientific evidence indicates that the current trajectory points towards a 3°C increase, which poses serious concerns from a banking supervisor's perspective. Delaying the transformation of the economy increases the disruptive nature of the transition and amplifies risks on banks’ balance sheets.

According to a recent ECB analysis covering 95 banks and accounting for 75% of euro area loans, the credit portfolios of banks are significantly misaligned with the goals of the Paris Agreement. This misalignment exposes roughly 90% of these banks to elevated transition risks, primarily stemming from exposures to companies in the energy sector lagging behind in transitioning to low-carbon production processes.

Moreover, Elderson notes that 70% of these banks could face heightened litigation risks due to public commitments to the Paris Agreement, despite their credit portfolios not aligning measurably with it.

Elderson stresses the importance of banks collaborating with their counterparties to ensure alignment with net-zero commitments, particularly in light of the surge in climate litigation targeting corporates and financial institutions globally.

Currently, many banks derive a significant portion of their interest income from counterparties in carbon-intensive sectors, exposing them to substantial transition risks. Elderson emphasizes the necessity for transition planning to become an integral part of standard risk management practices, anticipating that transition plans will eventually become mandatory.