Sustainable finance

Wake up to climate risk, central bank warns

From 1980 to 2017, losses caused by weather and climate events cost €718 million. (Photo: Matic Zorman/Maison Moderne)

From 1980 to 2017, losses caused by weather and climate events cost €718 million. (Photo: Matic Zorman/Maison Moderne)

Although the physical climate risk seems limited in Luxembourg, the transition to a less carbon-intensive economy will have a significant impact on the financial sector, Luxembourg Central Bank (BCL) says, calling on professionals who are still "timid" about climate change to become aware of the transition risk.

Physical climate risk refers to potential direct losses due to weather events. Since 1980 they have been steadily increasing in the European Union, the BCL says in the latest issue of its financial stability review. From 1980 to 2017, losses caused by weather or climate events accounted for 83% of total losses due to natural hazards, or €426bn. In Luxembourg, these losses amounted to €718m.

The loss per capita is €1,627 per inhabitant. This places the grand duchy in third place among the countries most affected in the EU, behind Denmark and Austria. 59% of these losses are, however, insured, which places Luxembourg in third place among the best covered countries in the European Union in the event of meteorological or climatological events. Only Denmark and Belgium do better.

Physical climate risk is of little concern to Luxembourg banks “insofar as their exposures are mainly concentrated in geographical areas with low vulnerability to extreme weather events,” says the BCL. The total amount of risk-weighted exposures reached €227bn in December 2020. For the record, the total balance sheet of Luxembourg banks amounted to approximately €863.4bn in December 2020. However, the BCL insists that "although the banking sector in Luxembourg seems to have little exposure to physical risk, its impact should not be underestimated, as certain climatic phenomena occur suddenly and devastatingly.”

High transition risk for the financial centre

The BCL seems to be more sensitive to transition risk, which is defined as “the potential impacts on financial stability of a rapid or abrupt transition to a less carbon-intensive economy in order to limit the impacts of climate change.”

A transition that could be implemented rapidly through legal constraints. Professionals are beginning to anticipate what could be decided at COP26 in Glasgow.

Banking institutions are particularly sensitive to this type of risk because of their exposure to non-financial companies in carbon-intensive sectors. The analysis of loans to non-financial companies shows a steady increase in the Luxembourg banking sector's lending to carbon-intensive sectors of the economy, from €47bn in December 2016 to €63bn in December 2020--a growth of 32%. The manufacturing industry is the economic sector that benefits the most, with a 19% share of total lending to non-financial companies, followed by the real estate (14%) and trade (9%) sectors.

“In Luxembourg, it seems that there are no significant adjustments in the banking sector towards a reduction of climate risk,” the BCL says.

Growth in equity investments in carbon-intensive economic sectors

On the investment fund side, the analysis of debt securities shows a growth in exposure to the carbon-intensive non-financial sector in Luxembourg, from €154bn in December 2016 to €206bn in December 2020--a growth of 33% in four years. Here too, investments in manufacturing companies are the most significant.

Across all economic sectors, the study of debt securities issued by the non-financial sector also shows a 39% growth over the period, from €382bn to €532bn in December 2020.

The trend in equity holdings is similar, with non-financial companies in the carbon sectors held by investment funds growing by 43%, from €519bn in December 2016 to €740bn in December 2020. The study of equity securities of non-financial companies also shows a growth of 62%, from €984bn to €1,596bn between December 2016 and December 2020.

For the BCL, these figures show that the evolution of strategies towards low carbon sectors is still relatively timid, or even non-existent for the banking sector, which implies that a transition risk could significantly impact the financial centre in the event of a tightening of environmental policies and measures.

"In this context, it is essential that public and supervisory authorities act in a coordinated manner to ensure that the country's financial actors develop appropriate tools for assessing and monitoring climate risks on their activities and asset portfolios," it says.

This article was originally published in French on Paperjam. It has been translated and edited for Delano.