Assessing climate risk on the European financial system: a multi-scenario Analysis

Abstract

This paper investigates the impact of climate risk on the stability of the European financial system, with a particular focus on both transition and physical risk dimensions. Given the long-term and uncertain nature of climate-related risks, traditional econometric methods often fall short in capturing their systemic implications. To address this challenge, we develop a scenario-based framework grounded in realistic projections consistent to the theoretical framework of the Network for Greening the Financial System ("NGFS"), encompassing three climate pathways: orderly transition, disorderly transition, and hot house world. We model the relationship between climate risk drivers, European companies, and the financial system using vine copulas, enabling a flexible representation of complex dependencies. The effects of these scenarios on financial institutions are evaluated through key risk metrics (expected return, value at risk, and expected shortfall) conditioned on each climate scenario. Our results offer insights into how climate transition risks propagate through the financial system, with practical implications for financial stability assessment and systemic risk management. The primary contribution lies in integrating both transition and physical climate risks into a coherent and tractable risk assessment framework, offering valuable tools for policymakers, regulators, and financial practitioners. Results show a significant dependence of European financial system to brown companies and, thus, sizable losses in the disorderly transition scenario.