Climate Risk Moves to the Forefront as ECB Warns of Rising Economic Threats & Supervisory Pressure

Key Takeaways

• Short-Term Climate Risks Modeled: New NGFS short-term scenarios forecast that extreme climate events could cut euro area GDP by up to 5% by 2030—akin to the Global Financial Crisis in scale.
• Scenarios Reveal Supply Chain Vulnerabilities: Climate shocks in other regions, especially those rich in critical minerals, could still significantly impact euro area output and inflation through global supply chains.
• ECB Supervision Intensifies: While most banks now have leading climate risk practices in place, the ECB warns these are often too narrow, failing to cover all exposures, regions, and risk types.
• Stress Testing Gaps Remain: All banks now include climate risks in stress testing, but many still exclude nature-related risks and fail to integrate findings into capital planning.
• Transition Planning Coming in 2026: The ECB will begin informal supervisory dialogues this year ahead of formal assessments in 2027 under new EU prudential transition plan requirements.

Deep Dive

What was once dubbed the “tragedy of the horizon” has now become a clear and present danger. That’s the message from two recent ECB blog posts detailing the urgent economic and financial risks posed by climate change—not just in the long term, but over the next five years. Together, the entries highlight both the growing sophistication of climate risk modeling and the ECB’s sharpened supervisory expectations for banks across the euro area.

In one blog, Deutsche Bundesbank’s Sabine Mauderer and the ECB’s Livio Stracca spotlighted new five-year scenario analyses from the Network for Greening the Financial System (NGFS), warning that climate-driven shocks could shave up to 5% off euro area GDP, a downturn comparable to the Global Financial Crisis. Days later, ECB Executive Board Member Frank Elderson followed with an update on bank supervision, noting clear progress in how European banks assess and manage climate and nature risks, but stressing that practices remain too patchy and often fail to cover all relevant exposures and risk categories.

The NGFS scenarios outlined in the first post aim to fill a longstanding gap in short-term climate risk forecasting, a gap that’s become increasingly untenable amid escalating droughts, floods, and heatwaves. Unlike longer-horizon transition models, these five-year scenarios are designed to align with the decision-making cycles of central banks, supervisors, and financial institutions.

Each scenario imagines different trajectories based on how climate policy unfolds and whether extreme weather events compound across regions. From a sudden policy shift in 2027 to severe multiyear disasters, the outlooks are sobering:

• In the Disasters and Policy Stagnation scenario, Europe is hit by a wave of climate catastrophes beginning in 2026 (heatwaves, droughts, wildfires, floods) resulting in a 4.7% drop in GDP by 2030 and rising inflation.
• In the Diverging Realities scenario, climate shocks in mineral-rich emerging economies disrupt euro area supply chains and push output losses up to 1.8%.
• Even the best-case Highway to Paris scenario , where a timely, coordinated net-zero transition is achieved, still results in a modest global economic contraction, though the euro area fares comparatively well thanks to its early policies.

Crucially, the new models take into account the spillover effects of global events, compounding weather shocks, and the transmission of economic strain through supply chains, offering a more realistic picture of systemic risk than ever before.

The findings underscore the ECB’s growing emphasis on short-term risks, not just distant projections.

“With ambitious climate policies already in place,” Mauderer and Stracca write, “the euro area would gain from an early and globally coordinated net-zero transition.”

But delay, they warn, means deeper output losses and inflationary strain.

Supervisory Pressure Ramps Up

Meanwhile, Elderson’s follow-up blog confirms that climate and nature risks have become core concerns for ECB supervision, and that progress, while notable, is far from complete.

In 2019, fewer than 25% of euro area banks had given serious consideration to how climate change might impact their risk management frameworks. Fast forward to 2024, and that number has jumped significantly: 56% of banks now have at least some leading practices in place. But there’s a catch: those practices often apply only to a subset of exposures or regions. For example, mortgage portfolios (a central component of bank balance sheets) are still frequently excluded from transition and physical risk planning.

“There’s still a long way to go,” Elderson cautioned, particularly in comprehensively covering operational and market risks, quantifying climate impacts, and incorporating nature-related risks such as biodiversity loss.

From Good Intentions to Full Integration

Elderson’s blog charts the ECB’s increasingly firm supervisory hand. Since 2022, banks have faced escalating expectations and clear deadlines:

• By March 2023, they were required to have materiality assessments in place.
• By the end of 2023, they had to integrate C&E risks into governance, strategy, and risk management.
• And by the end of 2024, climate-related risks were expected to be factored into stress testing and internal capital adequacy processes (ICAAPs).

Banks that failed to meet these deadlines faced formal decisions and even the threat of periodic penalty payments (PPPs), with more assessments ongoing.

Encouragingly, all banks now include climate risk in their stress testing frameworks, a dramatic jump from 41% in 2022. Yet only a third incorporate climate risk into their capital planning, and most still do not comprehensively assess nature-related risks. The ECB sees this as a major blind spot, especially given evidence from insurers like Allianz and Swiss Re that climate-driven losses are mounting faster than expected.

Elderson highlights that many current models understate risks because they fail to account for tipping points and compounding events. With the world on track for 3.1°C warming by the end of the century, the stress on asset values, credit quality, and insurance markets could become systemic.

Transition Planning and What Comes Next

Looking ahead, the ECB will begin informal dialogues with banks later this year as it gears up to implement new prudential transition planning requirements tied to the EU’s revised Capital Requirements Directive (CRD VI). These plans, formally assessed starting in 2027, are meant to ensure banks are actively managing the transition to climate neutrality by 2050.

The ECB will also publish a new compendium of good practices later this year, building on lessons learned from the 2022 stress test and thematic reviews. And on October 1, it will host a supervisory conference to discuss progress, best practices, and persistent challenges.

For now, financial institutions cannot afford to view climate and nature risks as tomorrow’s problem. They are already eroding economic output, reshaping inflation dynamics, and exposing weaknesses in bank portfolios.

As Mauderer and Stracca put it, “Climate-related risks are an immediate concern for financial stability and economic growth.”

And Elderson agrees, the time for treating climate as a niche supervisory issue is long over.

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