Climate Change, Central Banks and Financial Risk – IMF F&D | DECEMBER 2019
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- Authors: PIERPAOLO GRIPPA, JOCHEN SCHMITTMANN, FELIX SUNTHEIM
- Published: December 1, 2019
Overview
- Climate change creates both physical risks (damage from cyclones, droughts, sea-level rise, extreme weather) and transition risks (policy, technological, and market shifts toward a lower-carbon economy).
- Measuring economic costs remains incomplete: immediate costs from weather events can be assessed, but most potential costs lie beyond the horizon of typical economic analysis and will depend on policy choices made today.
- Policymakers and investors increasingly recognize climate change’s implications for financial stability and the allocation of capital.
Channels of Financial Risk
- Physical risks:
- Direct exposures through corporations, households, and countries experiencing climate shocks.
- Indirect exposures via macroeconomic effects and feedbacks within the financial system.
- Example: rising sea levels and extreme weather can reduce property values and increase mortgage portfolio risk.
- Insurance and reinsurance face asset-side and liability-side pressures as claims increase in frequency and severity.
- Transition risks:
- Losses on assets tied to firms with high carbon-intensity as policies, technologies, and sentiment shift.
- Risk of “unburnable” fossil fuel reserves as demand and policy change (reference to Bank of England Governor Mark Carney, 2015).
- Example: coal producers face policy constraints; some large banks no longer finance new coal facilities.
- System-wide effects:
- Abrupt, poorly designed, or uncoordinated transitions can disrupt trade and lead to rapid asset-price adjustments.
- Markets may partly price climate risks, but asset prices may not fully reflect the potential damage or necessary policy action to limit warming to 2˚C or less.
Impacts on Financial Institutions
- Banks:
- Increased default risk in loan portfolios and asset-value declines.
- Potential for tighter financial conditions if lending contracts following widespread climate shocks.
- Insurers and reinsurers:
- Higher insurance costs or unavailability in high-risk areas.
- Reduced diversification as previously uncorrelated events become correlated.
- Asset managers and investors:
- Repricing of carbon-intensive assets; the emergence of a “carbon discount” in market valuations.
- Opportunities in financing mitigation and adaptation investments.
- Examples:
- Pacific Gas and Electric’s bankruptcy linked to climate-related fires (Gold 2019).
Regulatory Responses and Challenges
- Central banks and supervisors are integrating climate-related risks into supervision and financial stability monitoring.
- The Network of Central Banks and Supervisors for Greening the Financial System (NGFS) comprises 42 members and is developing guidance and analytical work.
- Prudential policy adaptations:
- Incorporate climate risk scenarios into stress tests (examples: UK prudential regulators including climate scenarios in insurance stress tests).
- Adapt prudential frameworks to assess long-horizon climate risks using new methodologies.
- Caution against policies that weaken prudential regulation (e.g., allowing lower capital charges solely for “green”-labeled debt could increase leverage if underlying risks are not properly measured).
- Monetary policy implications:
- Climate change can slow productivity growth, increase uncertainty, and raise inflation volatility.
- Central banks should consider adapting refinancing frameworks and haircuts to account for climate exposures.
- Central banks can integrate sustainability considerations into management of their own funds, pension funds, and, to the extent possible, international reserves (NGFS 2019 recommendation).
Financial Sector Contribution and Sustainable Finance
- Primary role of fiscal policies (carbon pricing) in reducing emissions and mobilizing revenue; financial sector plays a complementary role.
- Finance provides risk-sharing (insurance, catastrophe bonds) and can mobilize capital for mitigation and adaptation.
- Investment needs:
- Global infrastructure investments estimated at about $6 trillion per year up to 2030 (OECD 2017).
- Sustainable finance growth:
- Global asset estimates range from $3 trillion to $31 trillion.
- Green bond stock estimated at $590 billion in August 2019 from $78 billion in 2015.
- Mechanisms for investor influence:
- Engagement with companies, investor activism, and lending to sustainability leaders send price signals allocating capital to low-carbon activities.
- Risks and challenges:
- Measuring environmental impact is difficult.
- Greenwashing concerns may deter investment scaling if policy action lags.
IMF Role, Analytical Work, and Data Needs
- IMF mandate aligns with analyzing risks and advising members on macro-financial policies; integrating climate risks into these activities is critical.
- Stress testing enhancements:
- Improve stress tests within the Financial Sector Assessment Program to capture physical and transition risks.
- Recent country examples: scenario-based stress tests analyzing severe hurricanes and massive natural disasters for The Bahamas and Jamaica.
- Ongoing work: analysis of financial system exposure to transition risk in an oil-producing country.
- Collaboration and standard-setting:
- The IMF has joined the NGFS and collaborates on developing analytical frameworks for climate-related risks.
- Data and disclosure:
- Closing data gaps and standardizing climate-risk reporting in financial statements are crucial for accurate exposure assessment.
- Support for broader adoption of the Task Force on Climate-related Financial Disclosures (2017) recommendations to improve comparability and usability of disclosures.
- Overall message:
- Empirical assessment of climate costs is necessary; finance must manage the transition to a low-carbon economy to mitigate costs and capture opportunities for future generations.
Key Figures and Facts (verbatim)
- NGFS comprises 42 members.
- Target climate limit referenced: 2˚C or less.
- Global infrastructure investment need: about $6 trillion per year up to 2030 (OECD 2017).
- Estimates of the global asset size of sustainable finance range from $3 trillion to $31 trillion.
- Green bond stock: $590 billion in August 2019 from $78 billion in 2015.
- References cited: Carney, Mark. 2015; Gold, Russell. 2019; NGFS (2019); OECD (2017); Task Force on Climate-related Financial Disclosures. 2017.
Content based on "Climate Change and Financial Risk" by Pierpaolo Grippa, Jochen Schmittmann, and Felix Suntheim, F&D Magazine, December 2019.
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