Central banks up their game on climate change but need to go further and fast
By josh ryan-collins| @jryancollins
As central London was brought to a standstill last week by Extinction Rebellion protestors, leading central bank governors upped the ante on the need for the financial sector to face up to its responsibilities in facilitating a low-carbon transition.
In a joint letter to the Guardian, the heads of the Banque de France, the Bank of England and the Dutch National Bank said a failure to adjust to the reality of climate change posed an existential threat to financial institutions.
The comments came at the launch of the first comprehensive report of the Network for Greening the Financial System (NGFS), an international partnership of 34 central banks and financial supervisors from both advanced and emerging market economies.
Central banks have become concerned about this issue because climate change possess significant risks to financial stability: for example increasingly volatile weather events threaten large scale economic losses, whilst banks that have lent to fossil fuel companies may face losses if those firms fail to decarbonise their activities in time to meet expected new regulation that will manage such activities. One recent study estimated that the amount of investment at risk in the fossil fuel sector alone (a measure of “stranded assets”) to be around £1.6trn, assuming there is a shift to a 1.75-degree world by 2035.
The report recommended supervisors begin requiring financial institutions to integrate and monitor climate financial risks into their day-to-day risk-management operations. It also suggested that central banks should “lead by example” and start incorporating climate-related financial risks into their own portfolios (e.g. their pension funds) and disclose these risks publicly.
The Bank of England was first off the mark, with Governor Mark Carney committing the Bank to “disclose how financial risks from climate change are managed across its entire mandate”. This suggests, perhaps, that the Bank may go beyond its own funds portfolios and also consider climate risk in its monetary policy activity, e.g. its purchase of corporate bonds via Quantitative Easing.
This is all welcome news. But the key question is what criteria will central banks use to determine climate financial risk and what will they then do to reduce it on their own portfolios and balance sheets?
Understanding and defining climate financial risks remains a controversial topic. The report encourages more research and collaboration on the topic and emphasises the need for quantitative assessment of “different future scenarios”.
Underlying this approach is a strong faith in market-based solutions, in particular greater disclosure of risks. The idea is that disclosing more information will lead the market to better “price discovery” and a smooth adjustment away from risky “brown” assets.
However, as I argue in a new policy brief for the UCL Institute for Innovation and Public Purpose (IIPP), the complex and endogenous nature of climate change may make it almost impossible to accurately assign probabilities to particular climate change scenarios. Indeed, public policy and financial regulation in itself is a key factor in determining how we decarbonise the economy.
Under such conditions, the case for preventative or precautionary policy intervention to actively steer credit and investment away from “brown” sectors or potentially stranded assets, even if the form and level of financial stability risk is unclear, becomes stronger. To put it another way, it may be preferable to act now and suffer some short-term market disturbances in order to prevent much larger financial stability shocks in the future.
As economist and adviser on the UK Stern review Dimitri Zenghelis argued in a recent lecture for IIPP’s Rethinking Capitalism, it’s time regulators spent “less time predicting the future and more time designing it”.
Josh Ryan-Collins is Head of Research at IIPP, and has recently published a policy brief titled, Beyond voluntary disclosure: Why a ‘market-shaping’ approach to financial regulation is needed to meet the challenge of climate change.
Sign up to the UCL Institute for Innovation and Public Purpose’s mailing list to hear about our latest research, news and events. You can also follow us on Twitter: @IIPP_UCL.
