Policy Shift Weekly News: our selection of recent analysis on climate risk and sustainable finance

June 19, 2020

 

Every week, Policy Shift will share a selection of recent articles and publications focused on public policy and innovation. This week's theme deals with proposals and evolutions in the sustainable finance field and in climate change economic policy - notably in light of the Covid-19 crisis.

 

A report (in English) about climate physical risk and equity prices

 

By the International Monetary Fund (IMF), Chapter 5 of the Global Financial Stability Report focuses on the effects of climate change (physical risks) on equity markets, which are particularly sensitive to long-term risks and thus of interest for studying the effect of projected future physical risks on financial institutions. While the negative effects of natural disasters on equity markets and financial institutions have so far been mitigated by high insurance penetration, the high degree of uncertainty in the projections of climate variables and their economic impact does not allow the consequences of physical risks to be reflected in several climate scenarios - suggesting that equity investors are still paying insufficient attention to these risks. The chapter therefore stresses that, in addition to measures to mitigate climate change, measures to improve insurance penetration and strengthen the policy mix will help to reduce the negative effects of climate-related disasters on financial stability. The chapter also emphasizes the need to improve the measurement and disclosure of exposures to climate-related disasters in order to facilitate the pricing of physical risks.

 

Climate change risks to financial stability are receiving increasing attention from supervisors in view of the timeliness and severity of the effects of climate change. The acceleration of global warming - which is likely to reach 1.5°C between 2030 and 2052 if it continues to increase at the current rate (IPCC, 2019) - is exposing natural and human systems to high climate risks, including substantial degradation of ecosystem services (i.e. the material and immaterial benefits that humans derive from nature and biodiversity), significant sea level rise and increased frequency and severity of extreme weather events. Despite the degree of uncertainty associated with climate models and the non-linear effects of climate change on economies, particularly due to irreversible threshold effects, the IMF highlights the high degree of expert confidence in the materialization of physical risks and their consequences for financial stability, through two main channels : (i) the effect of natural disasters on financial agents with high direct or indirect exposure; and (ii) changes in the valuation of assets exposed to physical risk. The latter will also largely depend on adaptation measures, the magnitude of the transition risk and its integration into financial supervision (NGFS, 2019).

 

A policy paper (in English) about the role of financial regulation to help the low carbon transition

 

By the Institute for Climate Economics (I4CE), this policy paper raises the fundamental question of the role of financial regulation to help the financial sector to respond to the climate urgency. While it is broadly accepted that there is a need to ensure proper market functioning and financial stability – which are the traditional objectives of financial regulation, there is now broad agreement among regulators that regulation needs to evolve to better address climate issues, through the integration of climate risks for instance. However, the role of financial regulation in redirecting capital flows towards the low-carbon transition at the expense of "brown" activities is viewed as a highly controversial issue. The instruments to be used by regulators highly depend on the objective pursued – and while it will take time to fully integrate climate-related risks into financial regulation, other types of instruments can be adopted in the short term (i.e. raising awareness, set supervisory expectations, enhance disclosure and strengthen the supervisory processes). On the other hand, the paper underlines that other measures are more challenging – such as integrating climate-related risks into rules-based prudential regulations (which requires widely accepted risk metrics and robust risk assessment methodologies to address the "radical uncertainty" of climate change). I4CE thus raises a fundamental question: could financial regulation usefully complement economic policy measures to address certain market failures? Should the mandate of financial regulators be modified to allow them to pursue economic policy objectives in addition to their traditional objectives?

 

An economic analysis report (in English) about the need to leverage existing data and methodologies to counter the dearth of reliable climate risk information

 

By the European Systemic Risk Board (ESRB), this report highlights the need for positive measurements of the impacts of climate change in order to fill the “information gap” and shed light on financial stability risk exposures – despite discrepancies in climate change reporting by financial institutions. First, the report deals with the nature and severity of the magnitude of climate-related shocks on the economy and financial markets (while some scenarios estimate that physical damage from climate change could reach up to one-fifth of global GDP by 2100, there are considerable uncertainties around so-called amplifying dynamics). The ESRB underlines that in spite of uncertainties, “long-dated predictions are not needed to obtain a sense of the growing costs associated with physical risks”.

 

This is why the ESRB insists that “early action can avoid a situation in which physical and transition risks interact in a malign self-reinforcing way, whereby delayed mitigating action may yield physical disruptions, prompting abrupt additional tightening to keep temperature rises in check”. The report therefore goes on to stress that climate risk does not appear to be fully reflected in asset prices so far, with informational inefficiencies compounding climate-related capital misallocations (i.e. lack of carbon pricing; selection bias in firm reporting; lack of methodology for defining “green” and “brown” assets; no reporting on downstream emission intensity of products) and trends in past performance not representing developments going forward. However, banks and insurers' exposure to potential repricing of climate-related risks are most likely to be systemically important (due to bank concentration as well).

 

The ESRB concludes that it is of utmost important for policymakers, regulators and financial actors to concentrate on exploratory scenario analysis, dealing with data gaps, expanding financial modeling for the purpose of climate analysis, incorporating links to environmental science to allow for full cost-benefit analysis and therefore informing timely and tailored policy action. 

 

A supervisory guide (in English) about the integration of climate-related and environmental risks into financial supervision

 

By the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), this report sets out five recommendations for NGFS members to take action with regard to climate risk in financial supervision: (i) determining transmission channels of such risks to the economies and financial sectors and identifying how they are likely to be material for the supervised entities; (ii) developing a supervisory strategy and an internal organization to address these risks; (iii) identifying exposures of financial institutions to these risks and assessing the potential associated losses; (iv) setting supervisory expectations to create transparency according to the TCFD recommendations; and (v) setting up a toolbox to ensure adequate management of these risks by financial institutions and taking mitigation action. The report underlines the need for a collective international response to such risks, by harmonizing supervisory practices.

 

An academic paper (in English) about compound risk in the nexus of Covid-19, climate change and finance

 

By Monasterolo and al., this paper highlights that current responses to the Covid-19 crisis narrowly focus on public health and short-term economic and financial consequences, without considering how “pandemic risk” interplays with sustainable development goals (i.e. “interconnected risks”). The authors underline that risk compounds in the nexus of non-linear interactions among pandemic, climate change and finance. They show that neglecting such compound risk can lead to a massive underestimation of losses, which can be amplified by financial complexity, as well as to policies that impose unnecessary trade-offs among economic recovery measures, health and climate objectives.

 

This is why interdisciplinary research is needed to address such challenges, in order to inform effective policies and improve the resilience of our socio-economic systems against adverse scenarios.

 

A report (in English) about biodiversity risks for the financial sector

 

By the Dutch National Bank, this report assesses the dependence of the Dutch Financial sector to biodiversity (i.e. exposure to companies with high or very high dependency on one or more ecosystem services - one of them being animal pollination) before assessing its impact, in quantitative terms, on biodiversity (via the contribution in finance to companies involved in environmental controversies ; or via transition risk due to the transition to less nitrogen-intensive business models, for instance).

 

An editorial article (in English) about the development of new concepts of “existential risk management”

 

By Jakob Thomä, this article underlines that the broad majority of so-called ESG investment funds – such as mainstream funds – have suffered dramatic losses due to the Covid-19 crisis, and despite the fact that ESG funds are explicitly designed to manage such risks (working within the confines of environmental, social, governance norms and the regulatory environment enforcing them). He argues that “the pandemic is a failure of mainstream (and ESG) risk management frameworks”, and the ramp up of climate change, increased “unknowns” and geopolitical tensions requires financial institutions to develop new sets of tools to manage “existential risks” coming up, for instance by investing in long-term equity and credit research and by building better early warning systems.

 

A few articles on the Covid-19 crisis and the ecological transition

 

An article from Christina Figueres (former head of the UNFCC) about the need to reconcile the economic recovery package measures and the ones needed for global emissions to reach a sustainable trajectory (the International Energy Agency has recently published a report detailing policies for a “sustainable recovery”).

 

An editorial by Mark Carney (UN Special Envoy for Climate Action and Finance), Andrew Bailey governor of the Bank of England, François Villeroy de Galhau (governor of the Banque de France) and Frank Elderson (NGFS Chair) about how the pandemic offers a unique change to green the global economy. It stresses: “The pandemic has shown that we can change our ways of working, living and traveling, but it has also shown that making these adjustments at the height of a crisis brings enormous costs. To address climate breakdown, we can instead take decisions now that reduce emissions in a less disruptive manner. That requires us to be strategic. To build back better. This will only happen if financial decisions, including those made by businesses, investors, banks and governments, take the climate crisis into account. The economic recovery plans being developed today offer the chance to build a sustainable, competitive new economy”.

 

 

A striking recent climate science publication (also available here) about “climate sensitivity”

 

A recent scientific publication deals with climate sensitivity – the prime indicator of climate risk - stressing that recent modeling data suggests that the climate is “considerably” more sensitive to carbon emissions than previously believed. While it has been believed to be around 3°C since the 1980s (i.e. the amount of warming projected from a doubling of CO2 from the pre-industrial level of 280ppm), it is now projected to be around 5°C. The article stresses the role of clouds, whose net effect could be warming, while underlying that it does not take into account tipping points in the biosphere – revealing the fragility of the Earth system. 

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