In a blog post marking the publication of a report on 'Risks from misalignment of banks’ financing with the EU climate objectives', ECB board member Frank Elderson,  says it is crucial for banks to identify, measure and − most importantly − manage transition risks, just as they do for any other material risk.

"Eight years ago in Paris, global leaders reached a landmark agreement, committing to limit the global temperature increase to below the calamitous threshold of two degrees Celsius. Alarmingly, the latest scientific evidence indicates that we are currently on a global heating path of 3°C," he states. "Through the risk-based lens of a banking supervisor, this is seriously concerning - the longer we wait to transform our economy, the more disruptive the transition and the greater the risks that will materialise on banks’ balance sheets."

A recent ECB analysis of 95 banks covering 75% of euro area loans shows that currently banks’ credit portfolios are substantially misaligned with the goals of the Paris Agreement, leading to elevated transition risks for roughly 90% of these banks. The analysis shows that transition risks largely stem from exposures to companies in the energy sector that are lagging behind in phasing out high-carbon production processes and are late in rolling out renewable energy production.

Additionally, 70% of these banks could face elevated litigation risks as they are publicly committed to the Paris Agreement, but their credit portfolio is still measurably misaligned with it, notes Elderson.

"It is therefore vital that these banks do more work with their counterparties to ensure the companies they finance do not prevent them from living up to their net-zero commitment," he says. "This is more relevant than ever, considering that climate litigation has skyrocketed in recent years. Globally, some 560 new cases have been filed since 2021 and increasingly also targeted at corporates and banks."

As it stands, many banks are significantly exposed to transition risks and generate over 60% of their interest income from counterparties in carbon-intensive sectors.

Elderson warns: "Transition planning must become a cornerstone of standard risk management, as it is only a matter of time before transition plans become mandatory."