As the EU moves towards a decarbonised economy, financial institutions may face transition risks in their credit portfolios. These risks can, in turn, become drivers of credit, market, operational, and liquidity risk. To address the issue, the European Central Bank (ECB) recently published a report on alignment assessment for the European banking sector, with the goal of guiding these financial institutions towards alignment with EU climate objectives.
”Corporations in energy-intensive or CO2-intensive sectors to which financial institutions supply credit could experience reduced competitiveness as the transition towards a decarbonised economy takes place,” wrote ECB’s report. The reduced competitiveness could be a result of factors such higher carbon prices, asset stranding, and stricter environmental regulations, ultimately leading to a rise in the default risk of these corporations. In a corresponding blog post addressing the report, Frank Elderson, vice-chair of ECB’s supervisory board and a member of its executive board, emphasised the importance of transition planning, warning banks that “failing to plan is planning to fail”.
Being able to quantify transition risks is therefore crucial, and the ECB suggested alignment assessment as a method. Applied in this context, alignment assessment is a measurement of “the difference between a corporation’s production projection and targets set under a decarbonisation pathway”. A corporation that is misaligned would be assessed as adjusting its production more slowly than required under the decarbonisation pathway.
The method
In its report, the ECB used the open-source Paris Agreement Capital Transition Assessment (PACTA) methodology, which it encouraged banks to similarly apply to further develop their own alignment assessments. Transition risks were assessed for 15 different technologies in six key transition sectors, which, together, account for about 70 percent of CO2 emissions. Alignment was measured by comparing the rate of change in technology deployment to the rate of change required under a chosen decarbonisation pathway – the PACTA framework allows for a variety of pathways to be applied. The technology-level alignments – or misalignments – were then aggregated to present a net alignment rate for the institution under assessment.