Climate Change as a Prudential Risk for Central Banks and Regulatory Authorities

Why is Climate Change a Prudential Risk?

It has traditionally been argued that climate change is something that will only affect future generations and as such there are limited incentives on individuals and corporations to mitigate its effects now. This makes it important for the state, and its associated bodies and regulatory agencies, to play a role in engendering a longer-term view. Recent events, however, have shown that the time horizon for such future impacts may be much shorter than previously assumed, and indeed in many cases the effects are already being felt by populations across the world. This includes the physical effects of pollution and smog on people from heavily polluting carbon intensive industries and forest burning, as well as increases in global temperatures that are causing effects such as the Polar Shift and changing weather patterns, leading to increased occurrences of typhoons, heat-waves, floods, hurricanes and storms. The death, destruction and displacement arising from such events, and associated impacts on disrupted manufacturing capabilities, trade flows and supply chains, have an important effect on financial stability globally.

Institutions that have insured or lent to individuals and corporations affected by such events will see higher levels of claims and losses in those portfolios. In addition to such physical effects, there are impacts from transition effects. Traditional industries that are heavily reliant on fossil fuels are increasingly being shunned or facing greater regulatory burdens. One example highlighting this In the UK and France is the plan to end the sale of all diesel and petrol vehicles by 2040; another example is in the Netherlands, where all office buildings will have to have a C rated energy label by 2023 (currently 46% of bank loans there are collateralised against properties with lower rated energy labels, and many banks do not yet categorise energy level data in their risk management systems). As such, a larger portion of reserves of oil, gas and coal will therefore be likely to be left in the ground and hence written off from balance sheets. Credit ratings and share prices for coal companies have already fallen dramatically, and a similar situation could also occur to oil, gas and car companies that do not adapt in time. This in turn would affect the network of companies and individuals that support such industries, leading to wide-ranging impacts through the inter-connected financial system.

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Again, those institutions that are lending against and insuring the affected organisations will potentially see higher levels of claims, as well as increased non-performing loans and losses arising from such portfolios. They will need to update their lending policies and systems in order to account for these risks and will suffer financial losses and reputational risks if they are unable to adapt in time. It is therefore clear that the impact of climate change is a prudential risk that needs to be considered by financial institutions, as well as the Central Banks and Regulators that oversee them.

Actions Taken

So, what has been done so far about this from a Central Banking perspective? In December 2016, the Financial Stability Board’s Task Force on Climate-related financial Disclosures (TFCD) issued its recommendations, calling (on a voluntary basis) for businesses to disclose climate impacts and opportunities, governance over climate risk at the board level and management, and processes in place to identify and manage these issues. A number of Central Banks and Regulators globally have been building on this.

China was one of the earliest countries engaging its financial players in reducing the effects of climate change, well before the TFCD’s recommendations were made. In 2012, the Chinese government approved a policy goal for building an ‘ecological civilisation’. A key part of this was the building of green finance, of which China is now one of the leading global players. The People’s Bank of China (PBOC) has taken a number of steps to promote green financial development through a combination of macro-prudential and monetary policy. Since 2017, the PBOC has incorporated green finance into its macro-prudential assessment system, which includes providing positive incentives for commercial banks to increase their stock of green credit and green deposits. The PBOC has also been a strong proponent of the domestic green bond market, which has seen rapid expansion over the last few years.

The Bank of England has been another early adapter and reviewed the UK insurance sector’s exposure to climate-related risks in 2015, and later did the same for the UK’s banking sector. Their conclusion was that climate change presented financial risks to the UK’s banking and insurance sector, through increased credit, market and operational risks. The Bank’s Financial Policy Committee will now consider macroprudential implications of the financial risks from climate change, and stress testing may in future include some climate-related scenario aspects.

In Australia, APRA announced in February 2017 that climate risk is a foreseeable and material risk to financial institutions and that it is an ‘important and explicit’ part of the agency’s considerations. Directors who fail to properly consider and disclose foreseeable climate-related risks could be held personally liable for breaching their statutory duty of care and diligence under the Corporations Act. APRA are increasing the emphasis on stress testing for organisational and systemic resilience in the face of adverse shocks. Their expectation is to see more sophisticated scenario-based analysis of climate risks at the firm level and incorporate this into their system-wide stress testing.

De Nederlandsche Bank (DNB) have undertaken studies of the Dutch financial system which showed that there were wider systemic risks emanating from carbon-intensive sectors, some of which were already crystallising. They are embedding climate related risks into their supervisory approach and are also further developing climate-related stress tests.

The wider acceptance of climate change related issues amongst Central Banks and regulatory Authorities can also be seen from the growth of the Network for Greening the Financial System. Launched by 8 Central Banks in December 2017, it has so far grown to 18 Central Banks and Regulatory Authority members and 5 observers composed of international organisations. The Network’s aim is to contribute to the analysis and management of climate and environment-related risks in the financial sector, and to mobilise mainstream finance to support the transition toward a sustainable economy.

Future Options

Several low and medium-income countries have already made steps in implementing regulatory instruments to facilitate the move towards a low-carbon economy. China, India, Pakistan, Bangladesh, Vietnam and Indonesia which have introduced mandatory prudential instruments to channel credit away from high-carbon towards low-carbon sectors (generally via lending limits).Whilst a number of Central Banks and Regulatory Authorities in higher-income countries are beginning to take account of climate change related risks for the institutions they supervise and across the wider financial system, it is possible to go much further and adapt financial regulations to account for climate-related risks. For example, under the Basel III regulatory framework, low-carbon lending is often seen as higher risk, having longer tenors, higher refinancing risks and lower liquidity, as well as being vulnerable to sudden policy changes. Given that the current regulatory framework does not explicitly account for climate-risks, the concepts of ‘brown-penalising’ and ‘green-supporting’ factors have been suggested. These could be applied to capital requirement calculations in order to better account for climate-related financial risks inherent in carbon-intensive lending. This could thus result in higher capital requirements for carbon-intensive assets, which in turn would then begin to redirect lending to low-carbon financing. China has already implemented such a framework, and banks require less capital for green loans than other types of lending. Nevertheless, implementing such factors carries risk, since reducing capital requirements for bank loans to low-carbon industries may lead to increased risk-taking (and potentially arbitrage), with banks taking on riskier lending to benefit from the reduced capital cost.

An extension of this could be to introduce a carbon-based capital buffer that would apply to carbon-intensive loans or sectors that banks have lent to. This would remove some of the inherent biases in the system towards lending to carbon-intensive industries and also facilitate a move to low-carbon lending.

A second avenue which regulators have already begun to explore, but which could take on additional prominence is climate-related stress testing. Modelling scenarios that address a variety of transition paths to a low-carbon economy can help to determine the potential impact on individual firms and the wider financial system from climate change. A climate stress test, however, presents severe difficulties around how to model climate-related scenarios, as well as assessing the impact of related second order effects. For example, what would a 2°C increase in temperature mean for a bank’s auto-loan portfolio? Central Banks already struggle to model the dynamic interactions between individuals, firms, the economy and the financial system, domestically and globally. Trying to add in global climate change factors and environmental policies on top of these will be very challenging. As such, financial institutions, Central Banks and Regulatory Authorities will need to start developing more robust modelling approaches, and more sophisticated data collection, extraction and analysis techniques, if they are to stand any chance of answering such questions.

An additional tool should be through the further widening and promotion of green / low-carbon financing options. The Green Bond market is already worth in excess of $250bn and is growing rapidly. Banks can provide capital market access for green bond issuers or can invest in the green bond market themselves. Several banks have started issuing green bonds, with the proceeds being used for projects with environmental benefits. As this sector continues to grow, it will encourage further investment in low-carbon industries and projects.

This article was first published in abridged form in the 2019 OMFIF Global Public Investor, available at this link (registration required)

Aziz Durrani is Senior Financial Sector Specialist in the Financial Stability and Supervision Pillar at the SEACEN Centre.