How Central Banks Should Tackle Climate Risks

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Stockholm (NordSIP) – Central banks remain laggards in the fight against climate change, according to a report by Lija Strašuna and Anna Breman, Economist and Group Chief Economist at Swedbank, respectively. The report argues that despite the significance of climate-related risks to financial stability much remains to be done by central banks.

According to the report, climate change creates risks from extreme weather, global warming and the transition to a lower carbon economy, consistent with Riksbanken’s view. The increased recurrence of extreme weather events will cause increased physical damage, which may cause scarcity, increase volatility in inflation and productivity. Global warming will hurt productivity by causing assets to be moved from productive activities towards otherwise unnecessary adjustments to a warmer climate.

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For central banks, a more direct risk may come from the stranded assets in industries that become obsolete following the transition to a carbon-free economy. Echoing concerns from the academic literature, the report warns about the risk of a carbon bubble, which “if not deflated early, could lead to a discounted global wealth loss of US$1-4tn, a loss comparable to the 2008 financial crisis”. Mark Lewis, Head of Climate Change Investment Research at BNP Paribas Asset Management has used the German energy industry to illustrate these concerns and show that the transition to renewable energy sources is already hurting the profitability of laggards like E.ON and RWE.

“The BoE remains one of the most active central banks in this respect, although it has been joined by others. Last year, the ECB became more vocal on the issue and joined the Network for Greening the Financial System (NGFS), established a year earlier. The Swedish Riksbank joined in December 2018,” according to Swedbank’s report. As of March 2019, there were 34 members of the NGFS (pictured above), which also included the French, German, Swedish and Norwegian financial authorities, ACPR, BaFin, Finansinspektionen and Finanstilsynet, as well as Bank Al Maghrib and the central banks of China, Japan, Malaysia and Thailand. “Among the major central banks, the Federal Reserve is probably the only notable exception; it has not engaged in any of these activities”, notes the report.

The report argues that there are four fronts that central banks could pursue to advance the cause of climate resilience. First and foremost, central banks could deploy their research resources to explore the structure and dynamics of climate change risk, particularly from a quantitative perspective. They can also demand better disclosures of financial institutions exposure to climate risks. Relatedly, central banks could also impose climate-related financial and prudential regulations. In Brazil, banks have to stress test their balance sheet against environmental and social stress and incorporate these risks into capital requirements is quite inspiring. Finally, Monetary authorities could also adjust their policy tools. At a time of central bank balance sheet expansion, a commitment could be made to allocate a specific share of assets to green initiatives. In the Eurozone, the quality of green assets has allowed them to meet the eligibility criteria of inclusion in the ECB’s purchases.

The enhanced participation of central banks in sustainable finance is clearly gaining momentum. Last week we reported on the recent ESG commitments by the Bank of France and the Dutch National Bank. Hopefully, others will follow in their footsteps.

Picture from Banque de France/NGFS (First NGFS Plenary Meeting, 11 February 2018 in Bali)

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