How central banks are tackling climate change risks

The case for incorporating climate change into macroeconomic modeling and investment decisions has never been stronger. Extreme weather events such as floods and storms have now become more frequent, and their impact on growth and inflation is increasingly visible and felt around the world. Recent research has shown how climate change can have a strong impact on the stability of the global banking system by increasing the frequency of banking crises in the medium to long-term.

The banking sector has a critical role to play in aligning the real economy with the Paris Agreement goals of limiting global warming to well below 2°C and achieving neutrality by 2050. However, even with this global awareness, fossil fuel financing is still ongoing. A recent report found how, despite the political push for greener investments and more investment transparency, 60 of the world’s largest commercial and investment banks have committed more than $3.8 trillion to the fossil fuel industry.

This is even more alarming as it has direct repercussions on financial systems. In fact, climate change has been impacting financial market participants through two main channels: via physical risks, such as damaging infrastructure and land, and as a transition risk, resulting from changes in climate policy, technology, and consumer preferences during the adjustment to a lower-carbon economy. Both trends have macroeconomic and financial implications and important consequences for central banks’ primary objectives of price and overall financial stability.

Because of this, central banks are increasingly acknowledging their important role in fighting the risks of climate change, and some important innovations have already been accomplished. The European Central Bank (ECB) has launched a new climate change centre, showcasing their commitment to climate change policy and indicating a potential change in its mandate and, regarding banking supervision, is planning a climate stress test in order to assess the impact on the European banking sector over a 30-year horizon.

In addition, the UK’s Bank of England recently became the first central bank to include climate change in its policy remit, signaling a historical shift in central banks’ mandate. In January 2021, the US Federal Reserve has launched two committees set up to deal with climate impacts: the Financial Stability Climate Committee and the Supervision Climate Committee, to deal respectively with macro and micro climate-related risks. And in early April 2021, the Basel Committee published two analytical reports on climate-related financial risks, discussing transmission channel and climate measurement methodologies.

Nevertheless, there are currently still major challenges in connecting climate risk drivers to banks’ exposures and in reliably estimating and incorporating climate-related risks in regulatory frameworks. Despite the existing range of methodologies developed, disputes mainly arise from the estimation process and the need of gathering reliable data associated with the long-term nature of climate change.

A number of central banks are now explicitly communicating the need for improved and harmonized climate risk pricing techniques and climate risk transparency in financial assets and balance sheets.

Currently, the Task Force on Climate-Related Financial Disclosures, a body created by the G20 Financial Stability Board to examine climate change in a financial stability context, encourages financial market participants to use its recommendations as a framework for disclosing climate-related risks. Moreover, this year’s G20 Sustainable Finance Study Group has set among its deliverables the need to take stock of existing initiatives on sustainability reporting and of the different approaches to identify sustainable investments.

Standardizing climate-related disclosures and making them mandatory could provide a major impetus to improved pricing of climate risks. This standardization trend, in turn, could promote the use of harmonized tools and innovative instruments in various policy areas.

Moreover, the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), an expanding group of central banks and supervisors that currently comprises 89 members and 13 observers from all around the world, has embarked on the task of integrating climate-related risks into supervision and financial stability monitoring. In March 2021, it published a set of indicators that would make it possible to track and understand how national financial systems could become greener.

Some central banks, particularly from emerging countries, are already considering more sophisticated policy measures such as green disclosure and reserve requirements. The Bank of Lebanon has already employed differential reserve requirements, with the goal of influencing the allocation of credit in favour of investment in renewable energy and energy efficiency.

Similarly, central banks could actively promote green differentiated capital requirements and counter-cyclical capital buffers that establish the correct pricing of carbon risks. The Central Bank of Brazil has been among the first central banks to issue binding amendments to its macro-prudential regulatory framework taking the exposure to environmental damages and risks into account.

While more work is needed and national commitments may differ, central bankers are becoming increasingly aware of their role in mitigating climate-change risks and now is a key moment to move towards step-by-step implementation.

The views expressed here are those of the author and do not necessarily represent those of the institution to which she is affiliated.