Climate change is becoming increasingly important to central banks thanks to its implications for financial stability. In a forum sponsored by Amundi, Central Banking convened a panel of experts to discuss the latest innovations, regulations and challenges the industry is facing in addressing climate change.
- Torsten Ehlers, Senior Economist, Bank for International Settlements
- Audun Grønn, Special Advisor to the Governor, Norges Bank
- Timothée Jaulin, Relationship Manager and Head of Supranational Entities Coverage, Amundi
- Moderator: Victor Mendez-Barreira, Staff Writer, Central Banking
What are the latest climate change innovations and measures your institution has taken?
Audun Grønn, Norges Bank: Norges Bank became a member of the Network for Greening the Financial System (NGFS) in December, so we look forward to further work in this area. In March, the bank made a consultation in response to the Ministry of Finance on a public report on climate risk and the effects on the Norwegian economy. Norges Bank, as an institution, has also obtained a certificate for being an Eco-Lighthouse, a certification scheme for enterprises seeking to document their environmental efforts and demonstrate social responsibility. However, climate issues in the central bank operations field are still at an early stage.
Torsten Ehlers, Bank for International Settlements (BIS): BIS is also an active member of various international forums on the topic, such as the NGFS, but has also been part of others – including the Group of 20 Green Finance Group and the Sustainable Finance Group – and is currently conducting research from various angles. We have begun an initiative to green our pension fund, and of course the BIS is also an asset manager for central banks, so we are offering an environmental, social and governance (ESG)-based product. We’re also starting to put together a green bond fund – products marketed exclusively to central banks.
Timothée Jaulin, Amundi: Amundi has been very active in socially responsible investing (SRI) and ESG strategies. The first SRI form was launched in 1989, but we really started to work on climate risk in 2012, and I was involved through a research institute working on long-term investors and how they can contribute to generate positive externalities by investing either contra-cyclically or by taking into account long-term price risk. Based on that work, we launched our first low-carbon indexes in 2014, and then worked on mobilising investors with the UN Environment Programme and its finance initiative. We launched the Portfolio Decarbonization Coalition in 2014 in time for the 2015 UN Climate Change Conference (COP 21).
Why has climate change become increasingly important for central banks?
Audun Grønn: Climate risk is a serious issue, and the prime responsibility to mitigate climate risk lies with governments and with fiscal policy. It’s important to use the market mechanism and pricing of emissions to influence the behaviour of market agents to move in a greening direction. With regard to central banks, climate risk may impact the macroeconomy and financial stability, and in a transition towards a low-carbon economy this can involve costs in the short term – and possibly also large costs depending on the policy measures to be taken to address climate change. This implies there could be some systemic financial risk ahead, which is something central banks are very preoccupied with. We should always work within our mandates, and, for central banks, that means taking a comprehensive or holistic view on all factors impacting the economy and the risks we face.
Torsten Ehlers: The key angle for central banks is probably the financial stability implications of climate change. There is research suggesting the potential implications are very severe. Of course, we don’t know what the exact consequences of climate change will be, but the probability of a severe impact on the economy, and hence financial stability, means it’s something that central banks should look at.
Timothée Jaulin: We share the assessment that there could be a risk to macro-financial stability in the medium to long term. This will go through a lot of impacts on economic actors and corporates, but also states and other types of institutions. As an asset manager this is something we need to anticipate by measuring this potential risk and making sure it is priced in or that we can reduce exposure to it. We’ve been looking at it through the perspective of managing assets and trying to anticipate potential shifts in value for which we wouldn’t be rewarded. Because central banks manage such large reserves, they can be exposed directly to consequences on the price of the assets on their balance sheet.
What sectors within the financial system are exposed to climate-related risks?
Torsten Ehlers: From a central bank’s point of view, and given that most central banks since the financial crisis now have a mandate for financial stability, it is definitely the banking sector. Banks hold a wide range of loans of corporates and others across a wide range of industries. The second is obviously insurance – insurance companies are already affected to some extent.
Timothée Jaulin: Behind these climate risk issues are physical risk and transition risk. Some sectors are more exposed than others – insurance because it is exposed at the liability and asset side, but banks as well because they are exposed to the broader economy. And that’s perhaps the key issue with climate change – that we think it will impact all sectors across the board. There will be many forces at work that would impact not only the banking, insurance and carbon-intensive sectors, but very likely all sectors that directly or indirectly generate carbon emissions.
What do you make of one of the main challenges to the community in analysing climate-related risks: the vocabulary and methodology used to analyse it?
Torsten Ehlers: There is still a lack of clarity regarding definitions, for instance, in the realm of financial instruments offered. We’re talking about green instruments, but sometimes it’s not so clear as standards might vary internationally. That’s not easy for investors to figure out, as even for green bonds there are different providers of certification. One instrument that central banks have become more comfortable with is stress tests. Some central banks have started to do climate stress tests, but there are various issues around that: what are the right scenarios? What are the models to be used? There are also issues with data.
Audun Grønn: There is a need to reach a common vocabulary. We need clear definitions, with the help of international co-operation. There is also the issue of taxonomy and classification of economic activities, to understand their degree of greening or non-greening. Central banks have a function to acquire, analyse and spread knowledge of risks, partly to inform their own decision-making on monetary policy and the assessment of financial stability, but also via public reporting to help underpin other actors’ decision-making in the economy.
Timothée Jaulin: Definitions are very important, as is common understanding of concepts, but this is very high level. When you try to translate that at a very granular level – perhaps the asset, sector or project level – it has to be considered that we want clarifications, but not to hinder the capacity to innovate. Also, we need to make everyone understand that carbon intensity doesn’t stop at carbon-intensive sectors – the entire economy relies on carbon-intensive input, and it’s something we need to be clear about to understand the chain of climate risk consequences.
Why are the market, central banks and other financial actors having difficulties accurately pricing climate-related risks?
Timothée Jaulin: It relates to the way risk models work; it’s very difficult to have a factor that will have an impact now on something likely to happen in the future. This is true for basic asset pricing theory, but also for the other models that central banks and regulators may be using. It’s a long-term risk with climate change, but it’s also a risk with very fat tails, so you’re combining the two main risk models that financial practitioners are using. Perhaps the other reason is that it is a world of uncertainty when it comes to the timing of regulation and technological changes.
Torsten Ehlers: It is important these risks are accurately priced. Starting with the presumption that some of these risks are not properly priced for understandable structural reasons, if these risks were properly priced a lot of investors would probably rebalance their portfolios towards greener assets because they have fewer risks. The pricing is particularly difficult, as a big part of environmental risks has to do with policy – which policies are put in place to counter climate change would have a huge impact on valuing certain assets.
How can central banks better integrate climate-related risks in stress-testing exercises, which can be very complex and costly?
Audun Grønn: International co-operation would be quite important, both multilaterally and bilaterally with other key central banks. Norges Bank is still at an early stage in incorporating climate risk into stress testing, and so needs to thoroughly consider how to do this in the future, but sharing experiences and knowledge with other central banks would be a crucial part of that process.
Timothée Jaulin: If there is sufficient transparency and reporting on the results of the stress testing, this can potentially have an impact on agents’ behaviour. In an ideal world, based on the result of the stress test we would see a change in the behaviour of companies when it comes to financing long-term fossil fuel assets that could potentially become stranded, and other types of stranded assets across sectors.
Having access to standardised, consistent and reliable data to analyse climate change is crucial. Why is achieving this a challenge for institutions?
Torsten Ehlers: There is more and more data available, yet it’s still at an early stage. With the Task Force on Climate-related Financial Disclosures (TCFD) and the Bloomberg report, the idea is to have consistent reporting on carbon dioxide (CO2) emissions by large companies, which has progressed very well. There are other data providers trying to do this, but when it comes to climate impacts there are various dimensions of data required, which you typically don’t need for other exercises or risk assessments.
Timothée Jaulin: We’ve made significant progress on the availability of scope 1 and 2 greenhouse gas emission data, largely due to the work of the Carbon Disclosure Project (CPD), the TCFD and other regulations worldwide that incentivise corporates to disclose their carbon emissions. All sectors need to be concerned because, indirectly, they are all using carbon-intensive inputs, and to incentivise companies to help support the transition to a low-carbon economy all sectors must do their part. It’s also very important to increase the availability of data related to solutions, hence the importance of positive metrics too.
Given the huge uncertainties around climate change, can a clear-cut risk assessment be delivered?
Torsten Ehlers: I would agree that the uncertainty is higher, but I wouldn’t be so negative because a lot of the risks stem from expectations of what future policies are going to be, and we can make some assumptions about that. For instance, we can make the assumption that a given country has ratified the Paris Agreement on climate change and they’re going to fulfil their commitment, so that will imply a certain path of CO2 emissions and hence a certain emissions reduction target.
Beyond technical exercises and data that should underpin analysis, is it necessary to modify current institutional agreements, or should central banks modify their mandates to include mitigation of climate change in their policy objectives?
Audun Grønn: Climate risk is a source of financial risk, and it is therefore important for central banks to take this into account in their overall risk assessments. When it comes to institutional arrangements and modified mandates, specific climate risks are not currently in central bank mandates, and I believe it should not specifically be in the mandate.
Should central banks take a more active approach and implement active policies to foster this change in the economy and the transition to a greener business model?
Audun Grønn: We have to be careful. It is important for central banks to raise awareness of climate risk among market participants and supervisors, but we should avoid the political sphere, and preserve central bank professionalism and independence. In promoting a transition towards a greener economy, central banks must always focus on safeguarding financial stability. We should be alert to and avoid special regulatory arrangements for green assets. Investors need to manage climate risk on a par with other risks. Of course, raising awareness of these risks may lead to a shift towards green assets, and subsequently a bigger market for those assets will be a natural part of regulation.
Timothée Jaulin: There is the Paris Agreement as a common framework and, based on that, policy-makers need to take action that will have an impact on the risks to which various businesses are exposed. Central banks should have the capacity to assess these risks and factor them in. You don’t need a specific treatment for climate risk, but policies that are in line with the commitments taken by countries at COP 21.
Torsten Ehlers: Measuring risks correctly is the starting point, and to the extent that central banks can contribute by raising awareness – and, as supervisors, by having a dialogue with their supervised institutions – that would take care of most of the issues. We also have to acknowledge that, particularly in emerging markets, there are central banks that have also followed some of the policies previously mentioned.
Could the increasing transparency central banks are undertaking in disclosing climate-related risks be an example for the wider market to spread best practice?
Torsten Ehlers: Some central banks have done great work raising awareness – the Bank of England had one of their early reports on the financial stability impacts of climate change on the insurance sector. Other central banks, such as The Netherlands Bank, are seriously considering this topic, as is Banque de France and the People’s Bank of China. There is already a lot of progress being made, and the NGFS brings a lot of central banks together and has an important role of distilling all the work that has already been done.
Audun Grønn: I agree with spreading best practices, and also the role of the NGFS in addition to individual central banks. The NGFS has structured workstreams, so they’re looking into various issues, and it’s a systematic building-up of knowledge and competence in this area. If you look at the membership of the NGFS – it’s 36 central banks and supervisory authorities and six international observer institutions. It is heavily advanced-economy-oriented – particularly western Europe. There are also some central banks of advanced economies missing from the NGFS. I would not make a strong distinction between advanced and emerging economies in this context because every economy has the opportunity to join, and there are other international institutions where they can co-operate, such as the International Monetary Fund, the G20-based Financial Stability Board and the BIS.
Timothée Jaulin: Co-operation is already there, and I don’t see emerging market institutions really lagging behind. In Asia, many institutions have been at the forefront of these issues, especially on the topic of green finance. China has been a leader, but we have also seen Hong Kong make an announcement recently and the regulatory authority of Singapore sign a memorandum of understanding with the International Finance Corporation on the topic of green bonds. We’ve seen interesting initiatives in India, Bangladesh, Indonesia, Malaysia and Mexico.
Torsten Ehlers: I also see emerging markets taking the lead. There might be an issue of very small emerging markets that are already affected very heavily by climate change, and here the international community has some initiatives in place.
In analysing the adoption of investment criteria by central banks and ESG criteria, major institutional investors have moved away from carbon-intensive sectors. Should this practice be pursued by central banks in their portfolio management?
Torsten Ehlers: Different central banks have quite different investment needs and sometimes mandates, but there are various strategies in this direction – such as negative exclusion strategies – and positive strategies, such as a greater focus on assets associated with corporations or governments that have lower carbon emissions or more ambitious carbon reduction targets.
Timothée Jaulin: It’s coming from public finance institutions, central banks, public pension funds, sovereign wealth funds and other institutions. One thing that is important for public finance institutions is the step before the ‘how’ – the ‘why’. Why do you want to integrate ESG factors in your investment policy? Is it because of value reasons, to manage or protect the reputation of your institution? Or for risk management and return enhancement, or policy objectives? It’s important to be clear about the reasons you are establishing an ESG policy.
Audun Grønn: For Norway’s Sovereign Wealth Fund (SWF), the Government Pension Fund Global and the ESG investment criteria, this work is based on a mandate given by the Ministry of Finance, so it’s a political mandate. Regarding environmental issues, the SWF has a dedicated green portfolio; for social criteria or exclusions, there is an Ethics Council giving recommendations to the central bank; and for governance issues relating to the transition to a low-carbon economy, there has been a lot of emphasis on good corporate governance.
This is a summary of a forum convened by Central Banking and moderated by Central Banking staff writer Victor Mendez-Barreira. The commentary and responses to this forum are personal and do not necessarily reflect the views and opinions of the panellists’ respective organisations.
This feature is part of the Central Banking climate change focus report, published in association with Amundi