Climate Change and the Financial Sector

Climate Change and the Financial Sector

Author(s):

Anton Belgrave

According to the sixth Intergovernmental Panel on Climate Change (IPCC (2018)), the average global surface temperature has risen by approximately 1°C since the late 19th century, with the pace of increase since 1970 being faster than in any other 50-year period over the previous 2,000 years. Even in the best-case scenario of immediate, rapid and significant cuts in greenhouse gas (GHG) emissions, the average surface temperature is expected to increase in the next 20 years by 1.5°C relative to pre-industrial levels.

Reaching net zero - the neutralisation of all man-made GHG emissions through offsetting measures - by 2050, has been described as the grand challenge of our time. Limiting the rise in global temperatures to 1.5°C requires nothing short of a total transformation of the energy systems that underpin our economies, requiring an estimated annual investment of US $4 trillion by 2030 (IEA (2021)). Achieving this objective will have significant implications for the financial system, and the regulators who aspire to influence its growth and stability.

Climate Change Risks

An emerging taxonomy has broadly divided the risk associated with climate change into:

(1) "physical risk" (i.e., damages to facilities, operations, and assets caused by climate change-induced hazards and conditions); and

(2) "transition risk" (i.e., losses resulting from a transition of production and consumption towards methods and products that are compatible with a net-zero economy).

Transition risk can also be divided into three subcategories:

a. Policy risk which refers to the risk that policies associated with the transition to a lower- emissions economy may raise costs, induce shifts in the location and nature of economic activity, and impose restrictions that affect the viability or profitability of certain industries.

b. Technological risk through which certain assets may suffer a fall in value due to technological obsolescence, and become "stranded".

c. Preference risk which refers to risks arising from shifts in investor and consumer preferences away from carbon-intensive products toward greener ones.

From a regional perspective, the physical risks are clear for small Caribbean economies, with the expected intensification in hurricanes and increasing possibility of long-term droughts. However, transition risks are equally important, even though large-scale extractive industries such as oil and gas, which are expected to suffer most, are not currently a feature of most Caribbean countries. For example, de-carbonisation efforts may affect tourism-based Caribbean nations as airlines attempt to reduce their carbon footprint.

Financial Sector Risks

Physical and transition risks are likely to manifest themselves as traditional bank risks such as credit risk, market risk, liquidity risk and operational risks rise.

Since banks and other financial firms significantly influence resource allocation across the economy through their intermediation function, their strategic decisions could determine whether the transition to a sustainable economy succeeds or fails. For example, high leverage may inadvertently provide too much funding to "non-green" institutions. In turn, continued emissions by those companies may further increase uncertainty about future climate pathways, since each additional ton of carbon emitted into the atmosphere further warms the planet and alters the climate.

If losses related to physical risk factors are insured, they can directly affect insurance firms through higher claims. Since the 1980s, the number of registered weather-related loss events has tripled. Inflation-adjusted insurance losses have increased from an annual average of around $10 billion in the 1980s, to around $55 billion over the past decade (BOE, (2018)). However, even if losses are insured, the burden can fall on households and companies, impairing asset values and reducing the value of loan collateral/security of banks and other lending institutions.

General insurance contracts are usually written on a one-year basis and are frequently re-priced. Already, there are examples of private insurance cover being withdrawn, negatively impacting property values. Furthermore, the Bank of England has reported that representatives from the insurance sector have warned that a +4°C world would not be insurable (BOE (2018)).

Risk Management

To address climate-related financial risks within the banking sector, the Basel Committee on Banking Supervision (BCBS) established a Task Force on Climate-related Financial Risks in 2020 which has drawn up a principles-based approach to improving risk management and supervisory practices related to climate-related financial risks (BCSB (2020)). These eighteen principles encompass climate-related risk mitigation by ensuring:

i. significantly improved board oversight and the explicit assignment of responsibility;

ii. the incorporation of climate risk into capital and liquidity assessment;

iii. the inclusion of the impact of climate risk drivers on credit risk profiles; and iv. the incorporation of scenario analysis by firms to test their business models.

The principles also recommend an enhanced role for regulators in terms of requiring banks to incorporate material climate-related financial risks into their business strategies, undertaking supervisory assessments of climate-related financial risks, and using climate-related stress tests.

In addition to the Basel recommendations, in May 2020 the Network for Greening the Financial System (NGFS) published a Guide for Supervisors to help integrate climate-related and environmental risks into regular, prudential and supervisory activities (NGFS (2020)). The NGFS Guide made five recommendations to supervisors and provided detailed guidance and examples on how to embed climate-related and environmental risks within a supervisory organisation through dedicated structures, describing several operational models that remain relevant.

However, Coelho and Restoy (2022) noted that despite the guidance provided by Basel, the challenges remain significant, leading to questions about the role and effective impact of regulatory guidance on the climate transition. In particular, Basel pillar 1 capital requirements are calibrated for a one-year time horizon on the basis of the historical loss experience. For climate-related financial risks, however, the historical loss experience is not available, and a more forward-looking approach is required.

Coelho and Restoy further note that Pillar 2 offers more scope for dealing with climate[1]related financial risks. Within the supervisory review processes, authorities have a wider variety of capital and non-capital-based tools that might be deployed to ensure the effective management of climate-related financial risks. For example, supervisors could use their assessments of firms' exposures to climate-related financial risks to seek, within a reasonable period of time, enhancements that ensure that firms properly identify, monitor, measure and control such risks.

In addition, these authors have argued that the actual effectiveness of prudential tools to steer banks' credit policies is uncertain, at best. Some empirical evidence shows that changes in capital requirements have little impact on banks' investment policies unless they are calibrated at a very high level. More importantly, macroprudential measures aimed at reducing exposures to carbon-intensive firms and sectors may not always be conducive to reducing aggregate climate-related financial risks.

In particular, a significant increase in capital requirements for exposures to companies that are deemed high carbon emitters (brown exposures), will likely limit the availability and affordability of credit to carbon-intensive industries, thus hindering affected firms from adjusting their business models due to constrained financial resources.

Similarly, a green-supporting factor, one that alleviates prudential requirements for green exposures, is unlikely to contribute to financial stability policy objectives. A reduction in capital requirements for green assets would cause a break in the fundamental relationship between risks and capital requirements as there is no conclusive evidence that green investments are less risky than other exposures.

Analysis by Chamberlin and Evian (2021) of French banks also support the limited effectiveness of differential capital requirements to drive desired climate outcomes. They firstly note that the while a "green supporting factor (GSF)" is supported by the banking industry, the risk differential between "green" and "normal" assets has not been demonstrated. More worryingly, these authors found that the even when applied, the GSF would have only a marginal impact on the cost of the loan, with the value of other public support measures 15 to 25 times greater than the GSF.

In contrast, transition risk provides regulators with a theoretical basis for penalising high-carbon-generating activities in the banks' capital structures. However, to have an impact on the cost of the project, Chamberlain et al (2021) note that the calibration must be extremely high. For example, a 250 percent increase in capital requirements would increase the cost of some harmful projects by 10 percent. In view of their results, they advocate the development and exploration of other prudential options.

Analysis by Dafermos and Nikolaidi (2021) on differentiated capital requirements is more positive. In their model, a green supporting factor means that a bank needs to hold less capital for loans provided to support activities that can lead to the reduction of carbon emissions. Conversely, a dirty-penalising factor is applied whereby banks hold more capital against loans that finance high carbon activities.

These authors found that differential capital can reduce the pace of global warming, thereby decreasing physical financial risks. However, they also note that this reduction is quantitatively small, but enhanced when used in combination with a green fiscal policy. Interestingly they also found that fiscal policies that boost green investments, amplify the transmission risks of green supporting factors and reduce the transmission risks of the dirty-penalising factor, thereby producing an effective climate policy mix from a financial stability point of view.

Challenges

The assessment of climate related financial risks requires new, unique, and granular data. This data is, at best, only partially available, even in developed economies. For example, it is challenging to aggregate data on firms and emissions in a straightforward way since data collection is often sparse and incomplete. Standardising global climate disclosures may help address some of these data challenges.

Climate change-related features are likely to become more salient and possibly amplify financial system vulnerabilities. For example, climate-related risks may increase the correlation of shocks and therefore the aggregate exposures of financial institutions in ways that are extremely challenging to model.

Given that historical data may have limited relevance for predicting future climate states, financial institutions have little historical guidance on which to base projections, suggesting that existing risk management models and frameworks may leave them inadequately prepared for climate-related risks. Nonlinear effects may further complicate efforts to mitigate and model climate related risks, as tipping points are difficult to predict.

Nonetheless, this has not stopped attempts at modelling. As noted by the NGFS (2021), most NGFS members are conducting climate scenario analysis for the first time, and many view the development of awareness and capabilities on climate-related risk as being as important as the quantification of the risks themselves. The exercise itself is resource intensive, requires significant upskilling among central bank staff, and practitioners report broad collaborative efforts are necessary with external parties such as metrological and academic institutions, external modelling teams and data providers, other central banks and international organisations.

The way forward probably entails combining agent-based models, general equilibrium models, and statistical methods which would then be used in conjunction with stress tests. However, despite the sophistication of these approaches, the limitations noted previously suggest that considerable margins of error should be attached to any analysis around climate impacts.

Nevertheless, the scale of the problem suggests even imperfect efforts will need to be undertaken. In September 2021, the European Central Bank released the results of its economy-wide climate stress test (ECB (2021)) which found that:

1. early adaptation costs are significantly lower than the medium- and long-term costs of inaction;
2. physical risks increase non-linearly over time and are expected to become very significant and;
3. costs stemming from climate-related risks are moderate for the average firm and bank.
4. However, if climate change is not mitigated, large and significant institutions, select geographic locations (such as southern Europe), and certain industries would bear significant costs, possibly leading to systemic events.

Similarly, Fernando et al (2021) find that even under a representative pathway with modest concentration increases in carbon dioxide, the GDP losses are around 3.2% of GDP by 2050. They note that costs could be amplified if financial markets re-price climate-related risks with additional losses between 0.5 percent to 1.5 percent per year for all countries except Russia, which experiences larger GDP losses across all scenarios by 2030.

Conclusion

At this stage, the evidence that a macroprudential framework can be constructed which is capable of containing systemic climate-related financial risks is tentative. First, the micro and macroprudential prudential regime, including the stress tests and scenario analyses embedded in the Pillar 2 framework, seems to be a more suitable approach to ensuring that banks have sufficient loss-absorbing capacity against systemic climate[1]related financial risks.

Second, the literature indicates that the application of tools such as increasing capital requirements for brown exposures or alleviating these requirements for green exposures seem to be modestly effective, would need to be applied globally, and may need to be applied at politically unpalatable levels to contribute to financial stability. Fiscal policy in the form of carbon taxation appears likely to play a complementary role to differential capital requirements and other macroprudential tools, and should at least be defensible in democratic regimes.

However, given the accelerating nature of developments in this area, financial institutions and regulators need to look carefully at their individual climate frameworks and begin to incorporate these frameworks into day-to-day business practices in as timely a fashion as possible, given the significant uncertainty in this area.

Adapted from the 2021 Financial Stability Report.

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