knowledge | 22 February 2019 |
Climate Change and the Irish Financial System - Governor Outlines Central Bank of Ireland’s Approach
There is a growing awareness amongst central bankers and regulators worldwide of the potential implications of climate change for both financial stability and monetary policy. This is clear from a recent report (October 2018) published by the Network for Greening the Financial System (“NGFS”), which is a group comprised of 18 Central Banks and Supervisors, including the European Central Bank and the Bank of England. One of the key messages of that report was:
“NGFS Members acknowledge that climate-related risks are a source of financial risk. It is therefore within the mandates of Central Banks and Supervisors to ensure the financial system is resilient to those risks. As set out in the academic literature, climate change will affect the global economy and so the financial system that supports it. The financial risks it presents are in consequence system-wide and potentially irreversible if not addressed. Exact pathways may be uncertain but it is foreseeable that financial risks may crystallize in some form through either the physical or transition channel, or some combination of them both.”
In the Monsignor Pádraig de Brún Memorial Lecture delivered in National University of Ireland, Galway on 5 February 2019, Professor Philip Lane, Governor of the Central Bank of Ireland (“CBI”), gave his views on the macro-financial implications of climate change in Ireland. He accepted the leading role of the CBI (as outlined in its mission statement) in “serv[ing] the public interest by safeguarding monetary and financial stability”. He also took a sector-by-sector approach in considering the likely financial impacts of climate change in Ireland which is summarised below.
1. Energy Producers
Although the energy production sector has already moved some distance along the transition path by increasing renewable energy production and announcing the closure of Ireland’s coal-using electricity plant at Moneypoint in 2025, much remains to be done to transform the energy production sector, including in relation to the future phase-out of peat. Energy suppliers will have to invest in new infrastructural roll-outs, including support for the switch to electric cars.
2. Household Energy Consumers and Homeowners
Households will face a number of challenges. These include: retrofitting homes in order to reduce energy consumption, much of which will have to be financed through home renovation loans; the rising cost of and/or more curtailed insurance due to the increased frequency of severe weather events which may result in homeowners having to build-up rainy day funds to cover these risk events; volatile house prices depending on climate-related property exposures; the financial implications of a shift from oil-powered to electric cars; and potential carbon-related shocks to financial asset values which could impact on the value of investment portfolios (eg pension plans).
3. The Corporate Sector
The corporate sector is expected to face parallel problems. Businesses will need to devote additional resources to retrofitting offices, factories and retail outlets. The commercial insurance market will face the same set of issues as the home insurance market and the move away from oil-powered vehicles will impact on companies transporting goods and supporting business related travel. Businesses will have to reduce their reliance on carbon-intensive technologies, requiring innovation and imitation of best practices from around the world. Firms that offer defined-benefit pension plans will also have to address climate-related market risks.
4. The Construction Sector
The construction sector faces particular challenges. Construction companies will be required to switch towards more environmentally friendly materials and production techniques. The economy-wide requirement to retrofit existing structures and ensure new-builds meet high energy standards constitutes a structural shift in the role of the construction sector in the economy. This in turn will require suitably skilled construction workers and supportive policies to be put in place.
5. The Agricultural Sector
The agricultural sector faces both transition challenges and opportunities. Farmers will need to grapple with the curtailment of greenhouse gas emissions and respond to possible environmentally-related shifts in consumer preferences. However, biomass fuels and afforestation are likely to present new opportunities.
6. The Government
The Government faces a range of challenges in relation to the public finances and the operation of the public sector. The public investment programme will need to devote sufficient resources to the retrofitting of the public housing stock, schools, hospitals and other publicly-owned buildings. Public investment will be required for climate adaptation, including protection against flooding and rising sea levels. It will also be required to support the energy conservation of the public transport system and play an important role in assisting domestic households in financing the carbon transition and supporting associated research and development activities.
The CBI’s Cross-Sectorial Strategy for Finance
Having assessed the potential impacts of climate change for specific groups, Professor Lane turned to the implications for the financial system and the challenges facing policymakers, financial regulators and central bankers. The long-term nature of climate change means that it does not naturally fall into the short-to-medium-term planning horizons of consumers, firms or policy organisations; this is the so-called ‘tragedy of the horizon’, a term coined by Mark Carney, the Governor of the Bank of England in 2015. Consequently, the CBI has a special responsibility to drive momentum in addressing climate change. Professor Lane noted the following as important considerations for the CBI’s strategy:
- Monetary Policy: This is challenged by climate change in a number of ways. An increase in weather shocks raises the volatility of inflation, sectoral relative price levels and output. Separately, the pace of a transition to a low-carbon economy increases the difficulty in assessing output with volatility and level of output being impacted by excessively-accelerated or excessively-delayed policy packages. In addition, the Eurosystem can have a significant impact on the market for green bonds through its asset purchase programme and collateral framework.
- Financial Stability: It is now commonly accepted that climate change constitutes a material financial stability risk, through physical shocks arising from severe weather events or the deterioration in the productive capacity of a particular region or through various types of transition risks. The CBI (and other regulators and supervisors) will need to ensure on-going monitoring of climate risks, and ensure that climate-driven test scenarios and stress tests are available which, by extension, may call for the adoption of certain macroprudential policies to mitigate these risks.
- Firms and Markets: Financial firms (banks, insurance companies, pension funds and investment funds) must assess the market and credit risks associated with climate change. The considerable structural changes associated with the carbon transition mean that historical correlation patterns will not provide a reliable guide to the future distributions of return. This will also impact on optimal allocation and risk management strategies in the design of portfolios and loan books with insurance companies facing additional challenges in modelling the implications of their liabilities (the risks they insure). In terms of supervision, regulators will need to conduct environmental/climate risk assessments in order to evaluate whether firms are meeting the expected level of risk management and ensure that climate-related risks are properly disclosed to savers and investors who are choosing between different investment plans. Regulators (including the CBI) will need to make their expectations of financial firms clear in relation to these matters.
- Disclosure and Benchmarking: Each financial firm (above a certain scale) will be required to calculate and disclose its carbon exposure on the basis of current and future business. Intermediaries will be have a similar obligation with respect to investment portfolios including the environmental, social and governance (ESG) characteristics of underlying securities. Such disclosure will inform both the climate-risk assessment policies of the regulators and the decisions of savers and investors. For such information to be effective, a degree of standardisation will be required and ultimately, benchmarks based on such information will need to be developed.
European and International Context
The CBI’s considerations form part of a larger European and international drive towards combating climate change with central banks and supervisors looking to deepen their understanding of the risks posed by climate change to financial stability by enhancing their climate and environment-related risk analysis and by introducing new disclosure requirements to improve the quality of data available for review.
Another component of moves in the financial sector to address climate change has been the threading of sustainable/green finance principles through all aspects of the financial system. The European Union has made it a priority to introduce legislation supporting sustainable finance, focusing initially on disclosures and taxonomy. Reflecting the demand for green investment opportunities, private sector organisations have already developed significant markets in green bonds and green loans and many leading global lenders have recently adopted the UNEPFI Principles for Responsible Banking. (For information on those initiatives, see our related briefings; available here: green bonds; green loans; Principles for Responsible Banking).
As outlined in this briefing, the CBI has acknowledged that climate-change poses a fundamental risk to financial stability. As regulatory and disclosure obligations and the cost of carbon-emitting activities are only likely to increase, it is important that all regulated entities, businesses and households prepare for measures which are likely to be introduced to address this risk and the costs associated with these measures.
This briefing is for general guidance only and should not be regarded as a substitute for professional advice. Such advice should always be taken before acting on any of the matters discussed.