While only a minority of central banks currently have specific sustainability responsibilities, a majority are performing greater climate risk management roles, particularly as it relates to mitigating climate risks that challenge the stability of the financial system. The reason is that neither price stability nor financial stability can be assured without factoring in climate risk into decision making and investments.
Following the successful 2015 Paris Climate Conference (also known as Conference of the Parties-COP2015), in 2017 a global coalition of Central Banks has been established to ensure that Central Banks play a supervisory role integrating climate risk into decision making as it relates to the global financial stability mandate of Central Banks. This initiative is called, the Network for Greening the Financial System (NGFS). The group now has 108 members and delivers systematic recommendations for action on climate, including building a stronger culture of risk understanding, establishing new supervisory best practices, and integrating climate risks into central bank operations. To join the NGFS, members are required to publicly acknowledge that climate-related risks are a potential source of financial instability for their countries. Essentially, financial authorities are leveraging their independence and proactively intervening to redirect and inform financial flows to ensure that they are in line with the “net-zero” transition and the threatening climate risk. Net zero is a state in which the greenhouse gases going into the atmosphere are balanced by their removal out of the atmosphere.
The Central Bank Role
Central banks perform their primary mandate of price stability, financial stability, and banking supervision. With new climate and social challenges however, come new responsibilities. The European Central Bank (ECB) for instance, has been ramping up its own climate role performing risk assessment to quantify the potential impact of climate events on the EU’s economy and the global financial system. The ECB has developed a multi-sector climate stress test of the entire financial system. This effort assesses the resilience of banks to various climate shocks and covers approximately four million companies worldwide and 1,700 European banks, representing 80% of all Euro area banks. The main results indicate that climate prevention cost may be high in the short term, but they are much lower in the long run than the costs of unmanaged climate change. Physical asset risks represent the greater climate vulnerability. In the banking sector, without more proactive resilience policies, the most vulnerable 10% of banks may see a 30-40% increase in the default rate of their credit portfolios between now and 2040. Central banks are also starting to include carbon prices (which includes accurate social cost) in in their monthly market assessment, regularly evaluating the impact of climate policies and the impact of extreme weather events on GDP and inflation and on general macroeconomic stability. The US Central Bank is following the EU lead and will increasingly play a climate role without becoming hostage of the political debate in Washington.
The Climate Risk
As climate induced extreme weather events become more frequent and intense, economic shocks become more severe affecting larger portions of GDPs. This, in turn, can expose the economy to greater volatility in output and prices and thus affect macroeconomic stability. Whatever combination of physical and transition risks materializes because of climate change, the macroeconomic consequences and financial risks resulting from the broader environmental crisis will be deep. These risk and consequences are clearly linked to the mandates of central banks and financial supervisors. According to several recent studies there is about $22 trillion in exposure to climate change risks over the next 10 years. Unless these risks are managed proactively, building resiliency across financial decision making and operations, the global economy could face 5 to 24 % of global GDP losses by 2040.
Conclusion
Extreme weather events are becoming increasingly frequent, disrupting business continuity, supply chains, threatening our agriculture, our food systems, and ultimately the livelihoods of all. Redirecting and supervising financial flows is essential to facilitate the green transition, and to safeguard economic stability and sustained living standards. Also, given the unprecedented reallocation of resources across the entire economy that is currently experiencing rapid decarbonization and climate resilient efforts, we need Central Banks to play more proactive roles to ensure an orderly transition. Finally, while the climate agenda continues to be politicized, the potential devastating future shocks due to climate change requires new thinking, new partnership, and new roles for the Central Banks. Central Banks can ensure that robust ex ante macroprudential policy are in place, stress testing become the norm, and resiliency maturity is enhanced in order to refocus our financial decision towards a less carbon intensive economy.
