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ESG: Central banks and systemic climate risk

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Whether you’re a proponent of ESG focused on financial or double materiality, it can be difficult to understand why central banks have become so interested in climate risk.

The reason is economic stability – there is a risk that the impact of climate change, either from a sudden or chronic climate risk impact, could undermine overall stability through the domino effect. If it happens in one country, given the interdependence of today’s global economy, it could spread around the world.

The job of central banks, or financial supervisors, is to maintain economic stability. They do this in a number of different ways, through monetary and fiscal policy. They issue money, act as lenders of last resort (to both the public and private sector) and set interest rates usually targeting low inflation – something much of the world is struggling with right now.

Overall, the goal is to maintain overall stability and help promote economic growth, which is especially important when commodity prices are increasing and volatile, as we see now with the prices of oil, natural gas and wheat. Economic disruption at the household level is often reflected at the national level.

What exactly are climate risks?

Given that both the physical and transition risks associated with climate change have the potential to present macroeconomic risks, it seems clear that such risks should be addressed and the banks should be building resilience to future shocks. To understand what they are, climate risks tend to be divided into two sets – physical and transition risks.

Physical risks are from things like property, land and infrastructure damage, disruption to supply chains and food systems, while transition risks are those risks arising from an evolving economy, one moving to a lower-carbon basis.

These range from increased carbon costs, compliance and regulatory requirements, and changes in policies, in technologies and process and, of course, consumer preferences.

The potential impacts include the sustainability of debt, the cost of sovereign debt and the creditworthiness of economies, as well as the overall domestic public finance of different countries.

In 2015 Mark Carney, then Governor of the Bank of England, warned that climate change was a tragedy of the commons, where individual users of a resource exploit that resource as much as possible without regard to its stewardship – ending in the destruction of the resource.

We are seeing that play out today in groundwater use in the US, over-fishing and habitat destruction and more.  He warned specifically of the threat to insurers, with anticipated impacts on property, migration and political stability, as well as food and water security.

There has undoubtedly been an increase in extreme weather. The drought affecting Ethiopia, Somalia and Kenya means over 23 million people suffering from hunger; and there has been flooding in Europe, floods and wildfires in Australia, wildfires in California, and the impacts seem to be spreading.

The latest analysis from global consultancy Cap Gemini and financial industry body EFMA said that insured losses from natural catastrophes have leapt 250% in the last three decades, with the figures for wildfires and storms growing even faster.

Significant financial impacts likely

Today, over 30% of insurers globally restrict investment in unsustainable companies, and more than 20% restrict insurance cover to unsustainable companies, according to the report.

These numbers are only likely to rise, and when something becomes uninsurable, it’s going to become increasingly hard to do anything with that asset or region.

The real decision is whether to act now or later, risking a disorderly transition caused by serious economic disruption. In a global market already under siege from conflict, growing resource scarcity, inflation and inequality, the impacts are likely to be significant.

The results of financial impact of stress testing, which banks use to measure risk and employ the consequent analyses to inform policy decisions, remain controversial, since the impact variation dependent on methodological assumptions can differ widely.

In the EU, where climate-related losses have been estimated at €487 billion between 1980 and 2020, the European Central Bank (ECB) undertook a climate stress test in 2021.

While Vice President Luis de Guindo said at the time that the results showed action today was necessary because costs will only increase in the future, many argued that the impacts would not be that large.

The ECB analysis showed a potential 10% reduction in GDP and that portfolios vulnerable to climate risk indicated a 30% higher increase of default. The danger is that everyone thinks it won’t happen to them, or argue about the premise and assumptions underlying the test.

Network for Greening the Financial System

While not all countries are taking action, around 114 central banks take the potential instability from climate risk seriously enough to have come together to create the Network for Greening the Financial System (NGFS).

The NGFS was effectively set up to manage the new landscape of risk which many financial institutions, from pension funds, to commercial banks to insurers, are not set up to handle.

The network is voluntary and has a goal of ‘enhancing the role of the financial system’ in managing climate risk and redirecting capital to investments in environmentally sustainable development.

It encourages its members with the identification of best practice from within and outside its members, with tools ranging from climate scenario planning to stress tests.

One such member is the Bank of England, which operates its Financial Policy Committee, or FPC, which looks at risks to the stability of the UK financial system.

Climate change risk to finance taken seriously after 2008 crash

Created after the 2008 financial crisis because of the realisation that there needed to be a single body that could identify, monitor and work to reduce systemic risks to the financial system, climate change is one of the sources of risk the FPC considers.

Climate risk could “affect the safety and soundness of financial institutions”
Elisabeth Stheeman, an external member of the FPC, recently warned that the impact of physical climate risk in the UK could “affect the safety and soundness of financial institutions that the Bank of England supervises, for example, by reducing asset values or resulting in lower profitability for companies, and through insurance losses, or losses on mortgages.

Inflation-adjusted insurance losses from climate-related damage have increased fivefold since the 1980s, to around $50 billion per year. And uninsured losses can be multiples more.”

While global policymakers and industry worldwide might have accepted that climate change poses increasing and material financial risks, that doesn’t automatically create action.

No matter what, there are going to be trade-offs and difficult decisions to be made. These risks cannot be addressed or mitigated by individual institutions alone, and that includes central banks.

Sarah Breeden, executive director for financial stability and risk at the Bank of England, warned that individual balance sheet approaches to net zero are not going to be enough.

Individual actions don’t matter as much as aggregate outcomes and that is something the financial system, and industry, must recognise if we are to be successful on the path to net zero.

Action on climate change must be taken now

Stheeman does say that while climate risks are foreseeable, they are uncertain, and we don’t know exactly when they will arise.

What matters most is that how they play out in future will be dependent on actions taken now. There are challenges that central banks need to address: the lack of climate risk disclosure by firms, an absence of clear sector-level climate policies, firms not internalising the cost of emissions and, of course, the short time horizon of some investors.

That’s why central banks are increasingly focused on transparency, and on understanding economic exposure to climate risks.

And that is why concern about climate change is going to affect investors, corporates, suppliers and customers alike. The system is changing, as are the expectations that underpin it.

While there may be hiccups on the way, an orderly transition to a lower-carbon, more sustainable future means that everyone needs to start taking action. Today.

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