Opening Address by Director Luís Laginha de Sousa at the “Sustainable Finance – Preserving ecosystems for future generations” conference

"Achieving net-zero will require a whole economy transition - every company, every bank, every insurer and investor will have to adjust their business models. This could turn an existential risk into the greatest commercial opportunity of our time.", Mark Carney, "The Road to Glasgow", Guildhall, 27 February 2020

Good morning, everyone.

Let me start by thanking Paulo Soares de Oliveira for the invitation to be here.

Let me also salute all the speakers and all those that will be attending this event, either physically or remotely through streaming.

It is a great pleasure to take part in yet another event on sustainability hosted by PSO.

This year, the stakes are even higher given the reference to "preserving ecosystems for future generations".

It is not easy to bring themes into central banks' thinking and functioning that are not immediately identifiable with their mandates.

It was not easy, and it is still challenging to incorporate sustainability, climate change and energy transition into the strategies, structure and processes of central banks.

You can thus imagine the challenge of embedding topics such as biodiversity and ecosystem preservation into our way of thinking, which appear so far away from a central bank's main concerns.

Bearing in mind these initial remarks, I will try to organise the messages I would like to convey to you around three main topics.

The first topic focuses on sustainability and especially on the energy transition.

Here, I will mention the path that has been taken so far and the main risks and opportunities for the financial sector.

And a lot of the things that are being done in this respect can be taken as a good proxy for my second topic.

My second topic is biodiversity loss.

This topic runs the risk of becoming the next 'big ticket item' in financial stability concerns, and as a result in the concerns of all entities having financial stability mandates, including central banks.

It is clear that the level of awareness in central banks regarding biodiversity loss is still far from that attained with energy transition, but we may get there quite fast and in a non-linear fashion.

The third topic I intend to address relates to a gigantic challenge we need to face in order to take sound sustainability-related decisions: I am referring to the data challenge.

Making sure that we have comprehensive, reliable, timely and cost-effective data is still - and it will continue to be - a central and crosscutting concern to deal with sustainability.

And I am pleased to note that this will be the subject of one of today's panels.

I am aware that a lot of what I say will not be a novelty to many of you.

However, we are dealing with matters where the main concern is far from bringing about novelty each time we address them.

The main concern is to make sure that the topics addressed are duly absorbed and reflected into the actions of economic agents.

Like last year, I want to be more comprehensive and leave each panel to hold a more in-depth debate on the various topics.

If, at the end, time still allows, I will try to summarise the key points I would like you to retain from my intervention into 3 or 4 simple sentences.

About a year ago, I had the opportunity here to map out the subject of climate change from a central bank perspective.

Since then the fight against climate change has strengthened its position at the top of the agenda amid global concerns.

This in spite of fierce competition from the pandemic, which is still out there.

Political, legislative, regulatory, scientific, technical and media initiatives are being held, while warning signals are also intensifying.

Despite the road already taken in the marathon that should lead us from Paris to carbon neutrality, we are still quite far from the finish line and need to increase the pace.

This is why events like this are very useful as moments of systematisation and knowledge sharing.

Also, the timing of this event is fortunate, given that we are only a few weeks from COP26, which has taken on the ambitious goal for the financial sector to "ensure that every financial decision takes climate change into account".

I. Energy transition - risks and opportunities for the financial sector

So, let me come into the first topic I want to deal with.

It is about - as I mentioned - sustainability, and primarily about the energy transition and the risks and opportunities for the financial sector.

The financial sector plays an absolutely critical role in the process of transition to a sustainable economy:

• On the one hand, it is undisputed that the balance sheets of financial institutions are affected by environmental risks and these need to be adequately managed to safeguard financial stability;
• On the other hand, the energy transition will only be possible if the financial system is able to finance a very significant volume of essential investments over the coming decades.

And, if financial stability is at stake, so is the ability of the financial sector to finance the transition.

We are faced here with a duality that is a particular case for the financial system of the concept of "double materiality" that applies to firms more generally:

• On the one hand, firms' assets and balance sheets are affected by the impact of climate change;
• On the other hand, firms' decisions or activities can contribute to aggravate or mitigate climate change.

Given the centrality of the financial system, whether in relation to the "stock" or in relation to the "flow" of resources directly and indirectly impacted by sustainability, it is essential to permanently ensure the resilience of the financial sector throughout the transition process triggered by climate policies.

And here, Banco de Portugal naturally has a vast field of action, both as an entity responsible for safeguarding financial stability and as a banking supervisor.

This action is obviously framed by our participation in the Single Supervisory Mechanism (SSM), common to euro area countries and other EU Member States.

So, it is justified to take this opportunity to give a little more detail about what the Bank has been doing, especially in two areas:

• One area has to do with the work that has been carried out in terms of assessing the financial risks arising from climate change;
• Another has to do with participating in the work of adapting the regulatory and supervisory framework.

As far as the assessment of the financial risks arising from climate change is concerned, the first step towards understanding the extent to which physical and transition climate risks can pose a threat to financial stability is to quantify financial institutions' exposure to these risks.

This is a challenging task in many ways because:

• Uncertainty;
• Long materialisation horizons;
• Non-linearity;
• Dependence on short-term action, the activity sector and location of exposures;

Are just some of the factors that make it particularly difficult to assess climate and environmental risks.

Even if I ignore the major issue of data availability for the time being (I will mention it later on), traditional risk measurement techniques based on statistical relationships extracted from past information are not suitable for assessing climate risks:

• Not only are physical risks largely unpredictable;
• But also transition risks have no historical precedent.

In spite of these difficulties, we want to contribute to building a path based on technical and scientific knowledge (instead of the typical "guessing" which, in the absence of technical and scientific knowledge, tends to fill its space).

This is why Banco de Portugal has recently published a study, which quantifies the Portuguese banking system's exposure to firms more sensitive to the transition to a low-carbon economy.

The results of this study suggest that around 60% of banks' exposures to non-financial corporations are in climate policy-relevant sectors, especially in the construction and real estate sectors, and to a lesser extent transport and energy-intensive industries.

In addition to the evaluation of risks to financial stability, the Banco de Portugal has also been actively involved in the ongoing work at the European level to adapt the regulatory and supervisory framework.

This work aims to encourage financial institutions to progress in identifying, measuring, and mitigating the climate and environmental risks that they are subject to, over a medium- to long-term horizon.

In this regard, I would like to recall that climate risk has been one of the main risks identified by the SSM since 2019, and that it has been gaining importance since then.

In line with the priority given to this risk, in November last year the ECB published an important Guide on climate-related and environmental risks. This Guide sets out supervisory expectations for significant institutions under its direct supervision.

A gap analysis in the meantime has revealed that the vast majority of European banks are still far from ensuring that their practices are aligned with supervisory expectations. And this means they will need to step up the effort to adapt their risk management models.

It is also worth noting that the Banco de Portugal has extended these supervisory expectations to less significant institutions under its direct supervision. Entry into force will occur in the second quarter of 2022. The aim is to ensure consistent and balanced treatment between supervised entities, while taking proportionality criteria into account.

In addition to the publication of the Guide, the ECB has also decided that the next stress test for the banking system, to be carried out by the SSM in 2022, will focus on climate-related risks - both physical and transition risks.

Even if the notion of "risk" is typically associated with a negative perception, we know that it does not need to be so in practice and that risk, if properly managed, is also typically associated with opportunities.

In this context, we should recall the words of Mark Carney, former Governor of the Bank of England and the Bank of Canada and Climate Finance Adviser to the British Prime Minister for COP26, when he said that the transition to a more sustainable economy could "turn an existential risk into the greatest commercial opportunity of our time".

Carbon neutrality implies a profound and radical economic transformation, which encompasses all sectors of activity and obliges non-financial corporations, insurers, banks and asset managers to adjust their business models.

The transition to a greener economy implies a very substantial volume of investment over several decades, which will only be achieved through an unprecedented combination of public investment and (much more) private investment.

In addition to the sheer volume of funds needed, the financing instruments will also need to be adjusted.

Sustainable investment projects involve innovative technologies and significant costs in R&D, incorporate a strong capital intensity and have very long implementation horizons (10, 20 or even 30 years or more). This requires the availability of instruments such as equity, quasi-equity, venture capital, in parallel with traditional bank credit and bond markets.

Here too, the question of data availability, reliability and comparability is crucial.

But before I talk to you about data, let me briefly introduce another topic that has been gaining relevance in the context of environmental sustainability concerns and which, as I mentioned earlier, may be the next 'big ticket item' of financial stability.

II. Is the preservation of biodiversity the next 'big ticket item' of financial stability?

The debate on environmental sustainability, especially over the last decade, has been largely dominated by the phenomenon of climate change. However, there are other phenomena that are also quite relevant, including from an economic and financial viewpoint.

Among these, I would like to mention biodiversity loss, which was considered the fourth biggest global risk in the 2020 Survey of the World Economic Forum (after infectious diseases; climate action failure; and weapons of mass destruction).

The rise of biodiversity loss in the ranking of global concerns is due to the intensification of several factors, including:

• Changes in land and water use;
• The depletion of natural resources;
• The proliferation of invasive species;
• Pollution;
• And climate change.

In addition to contributing to the increase in global warming, biodiversity loss affects the ecosystems' ability to provide a number of key services to the economy, including, among many others:

• The supply of food and commodities;
• Regulation services (such as pollination)
• And even cultural services (for example, nature as a driver of tourism).

Pollination is an important example of the economic relevance of ecosystem services. Pollination is increasingly threatened and does not have an appropriate artificial replacement. The estimated economic value of pollination is between 5% and 8% of the market value of global agricultural crops. It is not difficult to imagine the damage caused if this service were to be discontinued.

If we multiply this example by many others, we can easily come to the conclusion that the economic and financial analysis of biodiversity degradation is the same as that underlying climate change.

At the origin of this phenomenon is an externality that translates into misalignment between the private and social valuation of biodiversity services. The result of this is physical and transition risks that ultimately lead to financial stability risks.

But here too - in the risks and how to mitigate them - we can find opportunities.

I hope you will not misunderstand what I will say next.

It will take some time before central banks can speak about these matters with the level of confidence that is recognised of them in other issues. But even without mastering the subject, this does not prevent them from contributing to stimulating the discussion and it is in this sense that I would like my words to be interpreted.

With this cautionary note as background, there are many elements in this discussion that suggest that a country like Portugal can reap important benefits from biodiversity concerns.

• Think, for example, of the biodiversity services that our vast exclusive economic zone (EEZ) provides to humanity, and that should be paid for;
• Or, coming back briefly to climate change, consider our EEZ's potential for carbon capture in the context of an increasingly developed and all-encompassing carbon emissions market.

In view of their underlying potential, these are clearly two subjects that warrant attention both in the present and in the future.

Irrespective of where ecosystems are located, economic theory guides us on how to preserve them.

To fight biodiversity loss, it is important to ensure that ecosystems are a source of income and that the healthier the ecosystems, the higher this income. Finding ways to bring income to those who preserve natural capital and to charge the appropriate price to those who use it is what economic theory recommends.

However, as is often the case, what is conceptually simple is anything but trivial when it comes to practice.

Indeed, a practical solution aligned with economic theory requires a fundamental starting point, which is the ability to measure "natural capital" and identify both the activities that consume it and those that preserve, or even increase it.

This leads me to the third and final part of this address, which is precisely on the importance and challenges of sustainability-related data.

III. The challenge of data

A good assessment of risks - but also of opportunities - related to climate change and biodiversity loss and the corresponding appropriate asset valuation, depends critically on the availability, quality and comparability of data related to these phenomena.

And this, without forgetting the cost that obtaining these data might entail.

We actually need data that respond to various types of need, namely:

• Data that enable supervisors to monitor financial stability risks related to climate change and biodiversity loss;
• Data that provide investors with the necessary information to assess sustainable investment firms and projects (and to ensure that projects are effectively 'green' and not just 'green-washed');
• Data that inform the various stakeholders about firms' transition plans to more sustainable business models.

Over the past few years, institutions such as the IMF, the Financial Stability Board, the NGFS and the IFRS Foundation, among others, have developed several worldwide initiatives in this field.

The European Union has been at the forefront of this process, with initiatives such as, among others:

• The Taxonomy Regulation;
• And the proposals for a Corporate Sustainability Reporting Directive and a Green Bond Standard Regulation.

The Banco de Portugal has been accompanying these initiatives, both through its direct participation in fora that discuss these topics and through our role in advising the government on economic and financial matters.

In this context, I would like to point out that Banco de Portugal has shown particular concern about preventing regulatory arbitrage and greenwashing (that I have just alluded to).

To this end, we have been striving for the principles of effectiveness, transparency and proportionality.

Even if a substantial part of the Bank's activity in this area is not visible to the outside world, this does not mean that it is less relevant for our financial system and for our economy.

So, without being exhaustive, I would like to stress that we have consistently made the point that it is important to concentrate efforts on policies and instruments which, according to a risk- and data-based approach, are more likely to make an effective contribution to climate objectives.

We have also stressed that it is crucial to be transparent about the environmental impact of current and future activities, investments and policies, as well as to prevent overlaps and an excessive complexity of the regulatory framework.

Finally, we have argued that the definition of new rules and requirements should undergo a proportionality test. This is to avoid unduly penalising certain countries, firms or entities in the financial sector due to their small relative size, geographical location or nature and complexity of their activities.

Final remarks

My speech is already long, and I'm going to finish so as not to take time away from the experts on the various panels, who will certainly bring us new perspectives on these and other important topics on today's agenda.

To conclude, I would like to leave you a few short messages, hoping that they will remain alive in the memory of all who are attending this event.

We need to continue to focus on assessing risk (not only climate risk, but also biodiversity risk) and identifying the many interesting investment opportunities that the economic recovery and the energy transition will bring us.

To this end, we need to fil ln the data gaps and define reporting and certification requirements.

The energy transition is underway and it will speed up. Everything suggests there will be no postponement of deadlines or easing of new requirements.

This is why the national financial institutions cannot just wait and see.

In order to make the best use of the opportunities of the economic transformation ahead, institutions must integrate environmental risks into their business strategies and models, internal governance, risk management policies and disclosure.

The cost of acting only when the regulatory and reporting frameworks are complete will be much higher than the cost of acting right now, even with the limitations and data gaps that we all acknowledge.

Thank you very much.

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