ECB Working Paper on Pricing Climate Risk and How Financed Emissions Impact Bank Liquidity
SDG 13: Climate Action | SDG 17: Partnerships for the Goals | SDG 8: Decent Work and Economic Growth
Ministry of Finance | Ministry of Environment, Forest and Climate Change
The ECB (European Central Bank) Working Paper titled ‘Climate change, bank liquidity and systemic risk’ provides the first empirical evidence on how climate transition risks—specifically banks’ exposure to carbon-intensive borrowers—affect their short-term funding costs in the European repo market. While the repo market is traditionally considered safe due to its collateralized nature, the study reveals that “climate risks are priced in,” with significant implications for financial stability and monetary policy.
Key findings from the analysis of transaction-level data (2019-2022) include:
The Carbon Premium: Banks with higher financed emissions (emissions of firms they lend to) consistently pay higher borrowing rates. A one standard deviation increase in financed emissions translates into 7-12% higher repo rates on average.
Driving Mechanisms: This premium is a mix of a risk premium (compensating for credit risk) and an inconvenience premium (reflecting dealer banks’ sustainability preferences).
Market Stress Amplification: The carbon premium triples in size during periods of financial stress, indicating that climate risks exacerbate existing market vulnerabilities.
Monetary Policy Pass-through: Rate hikes are transmitted quicker to “brown” banks (those with high emissions), as they adjust to new policy rates approximately 7% faster than green banks.
What is an ‘Inconvenience Premium’ in climate finance? It is a component of the interest rate that reflects the reluctance of climate-committed dealer banks to provide cheap funding to peers with high carbon exposure. Unlike a traditional risk premium based on default probability, this premium is driven by the internal sustainability goals or voluntary climate commitments (like the Net-Zero Banking Alliance) of the lending institutions, which make it “inconvenient” or reputationally risky for them to support carbon-intensive portfolios.
Policy Relevance
While the study focuses on Europe, its findings are highly relevant for the Reserve Bank of India (RBI) as it finalizes its own framework for Climate-Related Financial Disclosures and green lending.
Strategic Impact for India:
Systemic Risk Monitoring: The study highlights the need for the RBI to integrate financed emissions into its systemic stress testing, particularly for public sector banks heavily exposed to coal and power sectors.
Refining Green Repo Markets: As India develops its green bond and repo markets, this data suggests that “green” collateral may inherently provide a liquidity advantage for banks during market downturns.
Monetary Policy Transmission: The “uneven pass-through” found in the study suggests that Indian monetary policy transmission could be fragmented if one segment of the banking sector remains heavily “brown” while another transitions quickly.
Sustainable Finance Taxonomy: These findings underscore the urgency of a national Green Taxonomy to help Indian banks accurately measure and disclose transition risks, preventing a sudden “repricing shock” in interbank markets.
Follow the full report here: Climate change, bank liquidity and systemic risk