ESG Focus: Central Banks Take On Climate Risk

ESG Focus | May 08 2019

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Central Banks Take On Climate Risk

  • Central banks will force financial institutions to account for climate risk
  • The Reserve Bank of Australia, a member of the willing, has detailed its concerns
  • Central banks have called for a massive reallocation of capital and a green rating system

By Sarah Mills

In a move expected to have major implications for the banking sector and the global economy, the majority of the world’s central banks have signaled their intent to ensure climate risk is properly accounted for in the financial sector.

They warned in the closing week of April that a “massive” reallocation of capital would be required to mitigate the risks of global warming and said the banking system needed to play a central role in this.

Members of the Central Banks and Supervisors Network for Greening the Financial System (NGFS), which includes 36 banks and supervisors from five continents responsible for two thirds of the global systemically important banks and insurers and half of global carbon emissions, called for collective action to manage climate-related financial risks in a bid to establish a global standardised approach to the issue.

The notable exception to the membership is the US Federal Reserve.

The tools at their disposal include monetary policy (they recognise former inflation targets may no longer be appropriate), capital requirements, regulation, quantitative easing, political influence (an unusual public announcement for central banks), research, and the development of a standard reporting protocol.

In late April, the NGFS issued six recommendations that will help central banks lay the groundwork for this project, and to ensure they have their own houses in order. They include:

  • Integrating climate-related risks into central banks’ financial stability monitoring and micro-supervision;
  • Integrating sustainability factors into own-portfolio (i.e. central bank portfolio) management;
  • Bridging data gaps between public authorities through joint working groups to identify gaps; sharing information and making information publicly available to through a data repository;
  • Building awareness and intellectual capacity among central banks and supervisors, encouraging technical assistance and knowledge sharing with their institutions and other wider stakeholders to better understand how climate factors translate into financial risks and opportunities;
  • Policymakers: Achieving robust and internationally consistent climate and environment-related disclosure framework for business climate exposures, particularly companies issuing public debt or equity, and in support of the recommendations of the Task Force on Climate-related Financial Disclosures;
  • Supporting the development of a taxonomy of economic activities risks. It asks policymakers to bring together stakeholders to work on a public taxonomy which would:
    • improve transparency;
    • reduce greenwashing:
    • help financial institutions identify assess and manage climate risks;
    • help improve understanding risks differentials between asset types; and
    • mobilise capital for green and low-carbon investments consistent with the Paris Agreement.

The central banks have already started building public awareness.

Australia’s own Reserve Bank (a member of the NGFS) deputy governor Guy Debelle in March named climate change as a “systemic risk” to the Australian economy.

Debelle singled out supply shocks to agriculture and fossil fuels as the major issues, which is not surprising given Australia’s heavy reliance on the two industries.

The key point for us is it's not just climate volatility. When countries really take action it's going to mean a negative income shock in Australia.”

Debelle also flagged the inadequacies of the bank’s inflation targets to deal with climate-related supply shocks.

The problem we have with an inflation target is that if there's an extreme weather event, the price of goods will go up, and output will go down. If you're targeting inflation, you have to tighten monetary policy. But if you're targeting nominal growth as inflation goes up and output goes down, you don't have to tighten monetary policy,” said Debelle.

The rest of the world’s central banks are grappling with the same issues.

Central banks have two main issues to consider in their risk assessment:

  • The level of mitigation taken to reduce carbon emissions;
  • How orderly or disorderly a transition occurs away from carbon.

Climate change poses financial risks in two ways:

  • The physical effects of extreme weather and climate conditions;
  • Any impact of the transition to a lower-carbon economy.

The first affects assets and productivity. But the latter can also cause problems for financial institutions through stranded assets.

The NGFS stance essentially pits the central banks against governments that have domestic policies that enhance climate risk.

The central banks have stamped it as their territory and right, claiming climate change is “a source of financial risk” that falls well within the mandate of regulators.

The NGFS announcement has sent a clear signal that financial risks can only be mitigated through an early and orderly transition.  They are also calling for more green financing and better risk assessment.

Green loans are already on the rise. The 21 largest commercial banks in China alone hold US$1.2trn in green loans, accounting for 10% of their aggregate loan  balance.

This in part reflects the People’s Bank of China’s introduction of a framework incentivising green activities, which implicitly disincentivises carbon intensive activities.

Other options that have been mooted include green quantitative easing, however, there needs to be greater standardisation of green assets as currently many of such assets do not meet the criteria.

The European Central Bank at present holds about 24% of the eligible green bonds issued in the public sector and about 20% of private sector green bonds – effectively a green quantitative easing.

Basically though, the central bankers seek a systematic approach across all countries to mitigate risk. They seek a new rating system for public and private sector investments – something organisations such as S&P are already working on, and a global standard for financial markets and public procurement.

It is expected that a full rollout should occur some time in 2021.

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