Based on the channels presented, the credit risk parameters will be affected by the cost increase (estimated using above presented GHG emission and carbon price increase). Two factors will have a role in the assessment of the direct carbon price impact:
GHG emissions: As GHG emissions increase, the impact of the carbon prices will be more significant. In December 2019, the European Environment Agency (EEA) published a data visualization on GHG emissions by aggregated sector. The energy supply sector is the most dominant in terms of emissions, followed by transportation and manufacturing industry (e.g. cement). These three industries are contributing to approximately 60% of the total emissions.
Cost pass-through rate: Represents the extent to which changes in marginal cost are reflected in the retail price. The literature mentions several factors that affect the CPT rate - market power, price elasticity, Armington elasticity (the level of substitutability between domestic and imported varieties of a good in a country), transportation costs, etc. (J. Sijm, K. Neuhoff and Y. Chen 2006). The CPT rate will differ across industries. Starting with the energy supply as the most carbon intensive industry, various studies are estimating a high percentage of the CPT rate, indicating resistance on a carbon price increase (J. Sijm, K. Neuhoff and Y. Chen 2006). This study incurs important policy implications, since the complete pass-through signifies that wholesale electricity prices will increase at least in the short run (A.S. Dagoumasa and M.L. Polemis 2020). The CPT rate of the manufacturing industry also varies, but, on average, the rate is slightly lower in comparison to the energy supply, due to the low CPT rates (between 30 and 50%) in cement, iron, steel and glass production according to the “Ex-post investigation of cost pass-through in the EU ETS” conducted in November 2015.
Banks are obliged to assess the overall impact of the adverse scenario accounting for the indirect impact through stressed macroeconomic factors (e.g. decreased aggregate demand, increased unemployment rate, etc.) besides the direct carbon price impact. Using information from the aforementioned exercise, banks are required to estimate credit impairments resulting from the materialisation of stressed scenarios, based in the IFRS 9 methodology (nGAAP if applicable). A list of the requested information is presented in the ECB stress-test methodology and Excel template file.
Banks are also asked to calculate how the fair value of market risk exposures in the scope of the exercise is affected by the carbon price shock – an assessment of the market risk. The starting point will be the fair value and notional value of the trading book positions on 31 December 2021. By assuming a full transmission of the carbon price shock on 1 January 2022, the impacts on the fair value of the equity/bond portfolios are investigated with a breakdown of several risk drivers such as equity, credit spread, interest rates, commodities, FX movements and others. These risk factors may not cover all market risk factors, so banks can also consider the risk factors included in the regulatory models. The ECB will provide banks with the information on GDP, the inflation rate, the unemployment rate, housing prices and details on stock price and bond price shocks for the stress scenario.
Besides the stressed (the disorderly transition) scenario, institutions are also asked to deliver a baseline scenario by applying macroeconomic factors projections from the “December 2021 Eurosystem Broad Macroeconomic Projection Exercise (BMPE)”, to the extent that their internal models require these variables as input.