Central banks and the regulators are increasingly recognizing the potential financial effects of climate change and are engaging in researches into their impact on financial stability.
There have recently been two events directly related to the global debates on climate change and the methods of dealing with its impact. The first was the publication of a report prepared by the United Nations Intergovernmental Panel on Climate Change, which sets out what needs to be done in order to achieve the objectives of the 2015 Paris climate agreement. The second was the announcement that the Yale University economist William Nordhaus is one of the laureates of Nobel Prize in Economics for his work on “integrating climate change into long-term macroeconomic analysis”.
The report of the Intergovernmental Panel on Climate Change shows that the efforts undertaken so far around the world in order to combat climate change are insufficient, and urges governments to take urgent action in order to significantly reduce greenhouse gas emissions over the next decade. The authors of the report warn that if the global average temperature rises 1.5°C, or, in the worst scenario, 2°C above the pre-industrial levels, the consequences may be catastrophic and will be felt as early as 2040.
If sufficient countermeasures are not taken, the world will suffer irreversible damage in the form of rising sea levels, loss of biodiversity and deterioration of terrestrial and marine ecosystems, including the possible extinction of coral reefs. These changes will also have far-reaching consequences for water supply as well as the health and the standard of living of the world’s population. Needless to say that the greater the warming, the more severe these effects will be.
Growing number of analyses
Regardless of the degree of pessimism of the individual analyzed scenarios, climate change may transform the global economy in a fundamental way over the next decades. At the same time, climate change and its effects pose a threat not only to the ecosystems and the economies, but also to the financial system. This threat has two dimensions: the physical and the transitional — related to the transformation of countries into low-emission economies.
In the physical dimension, climate change has the potential to increase the intensity and the frequency of extreme weather events such as floods, heatwaves and hurricanes. These events may lead to property damage, reduced productivity, and significant economic disruption that will lead to financial losses. Such losses could destabilize both the insurance industry as well as the banking system.
Additionally, the transition from a high-carbon economy to a low-carbon economy could cause major disruptions and losses for companies whose business models are directly or indirectly based on fossil fuels. This could harm not only the banks that provided loans to these companies, but also the investors who purchased their shares and bonds. Moreover, the tightening of energy efficiency standards may also affect financial exposures, including mortgage loans.
Therefore, both physical risk and the transitional risk are important for the financial sector — especially given the high degree of interconnectedness in the global financial system.
For some time now, we have observed an increased level of activity of central banks, financial supervision authorities, and international institutions, which are taking action aimed at counteracting and limiting the effects of climate change.
The central banks have already launched research into the effects of climate change for financial stability. For example, the Bank of England has analysed the exposure of the insurance sector in the United Kingdom to financial risks associated with climate change and is conducting a similar assessment for the banking sector. De Nederlandsche Bank (the central bank of the Netherlands) has examined the exposure of the Dutch financial system to sectors consuming large amounts of carbon dioxide and the potential losses associated with climate-related events. Climate-related financial risks are also examined in the academic literature using stress testing methods which take climate change into account or macroeconomic modelling methods.
However, the analysis of these threats is still at an early stage, among other things, due to the limitations faced by researchers. Firstly, the data necessary to analyze the financial system’s exposure to climate-related risks are not always available or sufficiently detailed. Secondly, determining which assets are exposed to climate risk is difficult and can lead to different conclusions concerning its significance and consequences. Thirdly, the assessment of the climate-related financial risks requires the modelling of dynamic interactions between macroeconomics, the financial system, climate change, and environmental policies.
Attempts have already been made to draw up a coherent and comparable analysis of the financial sectors’ exposures to climate threats. For example, the Financial Stability Board has established the Task Force on Climate-related Financial Disclosures, which formulated sector-specific recommendations concerning the ways in which companies could voluntarily disclose climate-related financial risks.
According to the authors of the study “Climate change challenges for central banks and financial regulators”, the scope of the central banks’ existing mandates allows for a more explicit inclusion of the risks related to climate change. They discuss various solutions, including the adaptation of the financial rules, reforms concerning the assets used as collateral, and even “green quantitative easing”. However, the objective of these measures would not be to support the financing of low-carbon investments, but to prevent the purchase of assets that do not meet the standards of financial risk. This risk is assessed using more complex methodologies that include climate-related criteria.
Some central banks, such as the De Nederlandsche Bank and Banque de France, are already taking into account climate-related financial risks in their operations by applying environmental, social and governance (ESG) criteria for their own investments.
Growing environmental consciousness of the financial system
The authors of the aforementioned publication also note that “green” assets are currently not popular because they are perceived as risky and illiquid. As a result, regulations such as the Basel III framework may unintentionally discourage green investment. Therefore, the key issue is whether the market is correctly assessing risk. If “green” assets are in fact less risky because they avoid the exposure to climate change risks, or even protect against it, then the existing regulatory framework can be adapted in order to reflect this.
In this context it should be mentioned that the EU High-Level Expert Group on Sustainable Finance has recently suggested with regard to the issue of sustainable financing that it could be possible to consider a differentiation of capital requirements for the “green” asset class. This would mean that the banks would be allowed to finance “green” loans for projects that can reduce long-term environmental risk with less capital.
Some of the central banks in emerging countries have already utilized tools with the clear objective of promoting green sectors. For example, the Bangladesh Bank has introduced a credit limit according to which at least 5 per cent of the bank loans should be directed to these sectors.
We can also see a clear change in the attitude towards risks arising from climate change. For example, the financial supervision authority of the United Kingdom has tightened its position on this matter. Its draft of supervisory statement published on 15 October 2018 includes proposals concerning, among other things, greater accountability of high-level managers of financial institutions for the risks related to climate change.
In December 2017, eight central banks and financial supervisory authorities (including the Bank of England, De Nederlandsche Bank, Banque de France, the People’s Bank of China, and the Bundesbank) established the Network for Greening the Financial System (NGFS), which aims to contribute to the development of environmental and climate risk management in the financial sector and to mobilize the mainstream of the financial industry to support the transition to a sustainable economy. Since then, the NGFS has been joined by seventeen new members and five observers.
The thinking about climate change has evolved in recent years. It is currently believed that the risks associated with climate change pose a unique threat to companies and may extend beyond the standard business planning horizons. This impact may be felt both physically and through the transition to a low-carbon economy, which may disrupt business models due to technological and political changes.
The risks associated with climate change are far-reaching in terms of scale and scope, affecting many companies and geographic areas. Furthermore, they relate to a long time horizon, which may discourage stakeholders from taking action here and now. Despite this, an increasing number of institutions are feeling the need to engage in early intervention aimed at mitigating the future financial consequences of climate change and supporting a smooth transition to a more balanced model of economic development.