Central banks and financial regulators are starting to factor in

climate change

Climate change is already a reality. Ever-more-ferocious cyclones

and extended droughts lead to the destruction of infrastructure and
the disruption of livelihoods and contribute to mass migration.
Actions to combat rising temperatures, inadequate though they may
have been so far, have the potential to drive dislocation in the
business world as fossil fuel giants awaken to the need for
renewable sources of energy and automakers accelerate
investments in cleaner vehicles.

But measuring economic costs of climate change remains a work in

progress. We can assess the immediate costs of changing weather
patterns and more frequent and intense natural disasters, but most
of the potential costs lie beyond the horizon of the typical economic
analysis. The economic impact of climate change will likely
accelerate, though not smoothly. Crucially for the coming
generations, the extent of the damage will depend on policy choices
that we make today.

Policymakers and investors increasingly recognize climate change’s

important implications for the financial sector. Climate change
affects the financial system through two main channels (see Chart
1). The first involves physical risks, arising from damage to property,
infrastructure, and land. The second, transition risk, results from
changes in climate policy, technology, and consumer and market
sentiment during the adjustment to a lower-carbon economy.
Exposures can vary significantly from country to country. Lower- and
middle-income economies are typically more vulnerable to physical
risks.

For financial institutions, physical risks can materialize directly,

through their exposures to corporations, households, and countries
that experience climate shocks, or indirectly, through the effects of
climate change on the wider economy and feedback effects within
the financial system. Exposures manifest themselves through
increased default risk of loan portfolios or lower values of assets.
For example, rising sea levels and a higher incidence of extreme
weather events can cause losses for homeowners and diminish
property values, leading to greater risks in mortgage portfolios.
Corporate credit portfolios are also at risk, as highlighted by the
bankruptcy of California’s largest utility, Pacific Gas and Electric. In
what The Wall Street Journal called the first “climate-change
bankruptcy” (Gold 2019), rapid climatic changes caused prolonged
droughts in California that dramatically increased the risk of fires
from Pacific Gas and Electric’s operations. Tighter financial
conditions might follow if banks reduce lending, in particular when
climate shocks affect many institutions simultaneously.

For insurers and reinsurers, physical risks are important on the

asset side, but risks also arise from the liability side as insurance
policies generate claims with a higher frequency and severity than
originally expected. There is evidence that losses from natural
disasters are already increasing. As a result, insurance is likely to
become more expensive or even unavailable in at-risk areas of the
world. Climate change can make banks, insurers, and reinsurers less
diversified, because it can increase the likelihood or impact of
events previously considered uncorrelated, such as droughts and
floods.

Transition risks materialize on the asset side of financial

institutions, which could incur losses on exposure to firms with
business models not built around the economics of low carbon
emissions. Fossil fuel companies could find themselves saddled with
reserves that are, in the words of Bank of England Governor Mark
Carney (2015), “literally unburnable” in a world moving toward a low-
carbon global economy. These firms could see their earnings
decline, businesses disrupted, and funding costs increase because
of policy action, technological change, and consumer and investor
demands for alignment with policies to tackle climate change. Coal
producers, for example, already grapple with new or expected
policies curbing carbon emissions, and a number of large banks
have pledged not to provide financing for new coal facilities. The
share prices of US coal mining companies reflect this “carbon
discount” as well as higher financing costs and have been
underperforming relative to those of companies holding clean energy
assets.
Risks can also materialize through the economy at large, especially
if the shift to a low-carbon economy proves abrupt (as a
consequence of prior inaction), poorly designed, or difficult to
coordinate globally (with consequent disruptions to international
trade). Financial stability concerns arise when asset prices adjust
rapidly to reflect unexpected realizations of transition or physical
risks. There is some evidence that markets are partly pricing in
climate change risks, but asset prices may not fully reflect the
extent of potential damage and policy action required to limit global
warming to 2˚C or less.

Central banks and financial regulators increasingly acknowledge the

financial stability implications of climate change. For example, the
Network of Central Banks and Supervisors for Greening the Financial
System (NGFS), an expanding group that currently comprises 42
members, has embarked on the task of integrating climate-related
risks into supervision and financial stability monitoring.

Given the large shifts in asset prices and catastrophic weather-

related losses that climate change may cause, prudential policies
should adapt to recognize systemic climate risk—for example, by
requiring financial institutions to incorporate climate risk scenarios
into their stress tests. In the United Kingdom, prudential regulators
have incorporated climate change scenarios into stress tests of
insurance firms that cover both physical and transition risks.

Efforts to incorporate climate-related risks into regulatory

frameworks face important challenges, however. Capturing climate
risk properly requires assessing it over long horizons and using new
methodological approaches, so that prudential frameworks
adequately reflect actual risks. It is crucial to ensure that the efforts
to bring in climate risk strengthen, rather than weaken, prudential
regulation. Policies such as allowing financial institutions to hold
less capital against debt simply because the debt is labeled as
green could easily backfire—through increased leverage and
financial instability—if the underlying risks in that debt have not
been adequately understood and measured.

Climate change will affect monetary policy, too, by slowing

productivity growth (for example, through damage to health and
infrastructure) and heightening uncertainty and inflation volatility.
This can justify the adaptation of monetary policy to the new
challenges, within the limits of central bank mandates. Central
banks should revise the frameworks for their refinancing operations
to incorporate climate risk analytics, possibly applying larger
haircuts to assets materially exposed to physical or transition risks.
Central banks can also lead by example by integrating sustainability
considerations into the investment decisions for the portfolios under
their management (i.e., their own funds, pension funds and, to the
extent possible, international reserves), as recommended by the
NGFS (2019) in its first comprehensive report.

Financial sector contribution

Carbon pricing and other fiscal policies have a primary role in

reducing emissions and mobilizing revenues (see “Putting a Price on
Pollution” in this issue of F&D), but the financial sector has an
important complementary role. Financial institutions and markets
already provide financial protection through insurance and other
risk-sharing mechanisms, such as catastrophe bonds, to partly
absorb the cost of disasters.

But the financial system can play an even more fundamental role, by
mobilizing the resources needed for investments in climate
mitigation (reducing greenhouse gas emissions) and adaptation
(building resilience to climate change) in response to price signals,
such as carbon prices. In other words, if policymakers implement
policies to price in externalities and provide incentives for the
transition to a low-carbon economy, the financial system can help
achieve these goals efficiently. Global investment requirements for
addressing climate change are estimated in the trillions of US
dollars, with investments in infrastructure alone requiring about $6
trillion per year up to 2030 (OECD 2017). Most of these investments
are likely to be intermediated through the financial system. From
this point of view, climate change represents for the financial sector
as much a source of opportunity as a source of risk.

The growth of sustainable finance (the integration of environmental,

social, and governance criteria into investment decisions) across all
asset classes shows the increasing importance that investors
attribute to climate change, among other nonfinancial
considerations. Estimates of the global asset size of sustainable
finance range from $3 trillion to $31 trillion. While sustainable
investing started in equities, strong investor demand and policy
support spurred issuance of green bonds, growing the stock to an
estimated $590 billion in August 2019 from $78 billion in 2015.
Banks are also beginning to adjust their lending policies by, for
example, giving discounts on loans for sustainable projects.

Sustainable finance can contribute to climate change mitigation by

providing incentives for firms to adopt less carbon-intensive
technologies and specifically financing the development of new
technologies. Channels through which investors can achieve this
goal include engaging with company management, advocating for
low-carbon strategies as investor activists, and lending to firms that
are leading in regard to sustainability. All these actions send price
signals, directly and indirectly, in the allocation of capital.

However, measuring the impact that sustainable investments have

on their environmental targets remains challenging. There are
concerns over unsubstantiated claims of assets’ green-compliant
nature, known as “greenwashing.” There is a risk that investors may
become reluctant to invest at the scale necessary to counter or
mitigate climate change, especially if policy action to address
climate change is lagging or insufficient.

The IMF’s role

The analysis of risks and vulnerabilities—and advising its members

on macro-financial policies—are at the core of the IMF’s mandate.
The integration of climate change risks into these activities is
critical given the magnitude and global nature of the risks climate
change is posing to the world.

An area where the IMF can especially contribute is understanding

the macro-financial transmission of climate risks. One aspect of this
is further improving stress tests, such as those within the Financial
Sector Assessment Program, the IMF’s comprehensive and in-depth
analysis of member countries’ financial sectors.
Stress testing is a key component of the program, with these stress
tests often capturing the physical risks related to disasters, such as
insurance losses and nonperforming loans associated with natural
disasters. Assessments for The Bahamas and Jamaica are recently
published examples, with a scenario-based stress test analyzing the
macroeconomic impact of a severe hurricane in the former and a
massive natural disaster in the latter. More assessments of this kind
are in progress or planned for other countries. The IMF is also
conducting an analysis of financial system exposure to transition
risk in an oil-producing country.

The IMF has recently joined the NGFS and is collaborating with its
members to develop an analytical framework for assessing climate-
related risks.

Closing data gaps is also crucial. Only with accurate and adequately
standardized reporting of climate risks in financial statements can
investors discern companies’ actual exposures to climate-related
financial risks. There are promising efforts to support private sector
disclosures of such risks. But these disclosures are often voluntary
and uneven across countries and asset classes. Comprehensive
climate stress testing by central banks and supervisors would
require much better data. The IMF supports public and private
sector efforts to further spread the adoption of climate disclosures
across markets and jurisdictions, particularly by following the
recommendations of the Task Force on Climate-related Financial
Disclosures (2017). Greater standardization would also improve the
comparability of information in financial statements on climate
risks.

The potential impact of climate change compels us to think through,

in an empirical fashion, the economic costs of climate change. Each
destructive hurricane and every unnaturally parched landscape will
chip away at global output, just as the road to a low-carbon
economy will escalate the cost of energy sources as externalities
are no longer ignored and old assets are rendered worthless. On the
other hand, carbon taxes and energy-saving measures that reduce
the emission of greenhouse gases will drive the creation of new
technologies. Finance will have to play an important role in
managing this transition, for the benefit of future generations.