Enhanced scenarios for climate stress-tests

Central banks and financial supervisors recommend that financial institutions run climate stress-tests, and several have developed their own. Climate scenarios are central to climate financial risk assessments. Moreover, conditional to additional factors, such as leverage, interconnectedness and climate policy credibility, financial institutions can absorb or amplify climate risks. Thus, climate stress-tests are a powerful tool to quantify the exposure of financial institutions to climate financial risks, to support investors’ climate risk management and central banks and financial supervisors on both micro and macroprudential measures.

Scenarios play a key role in stress-tests, including in climate stress-tests. The development of the scenarios of the Network for Greening the Financial System (NGFS) has been a pivotal development in the climate finance space. Going forward, we need to be aware that these scenarios are constructed without taking into account that the reaction of the financial system to the scenarios may impact, positively or negatively, on the realisation of this or that scenario. We refer to this circularity as the endogeneity of climate risks and it can cause a gap to emerge between the level of climate finance investments actually carried out and those assumed to be carried out in the scenario used in the climate stress-test.

Neglecting such endogeneity could lead to increased risks for financial stability. To address this challenge, central banks and financial supervisors can benefit from a recently developed methodological framework that connects processbased Integrated Assessment Models and the Climate Financial Risk model. This framework produces a new generation of climate mitigation scenarios that capture the key role of investors’ expectations, policy credibility and risk assessment within the realisation of the scenarios, yielding more robust climate financial risk analysis. This framework can be applied to the NGFS scenarios, and to different internal credit and financial risk models, to improve the relevance of climate stress-testing for decision making

Prudential transition plans: the great enabler for effective supervision and regulation of climate-related financial risks?

Prudential transition plans can be used in financial supervision and macroprudential monitoring to overcome some of the challenges inherent to assessing the climate-related financial risks that stem from the transition to a low-carbon economy. These challenges include the poor availability and consistency of data, modelling constraints, and the long time horizon over which risks may materialise. Prudential transition plans can provide supervisors with a multi-year account of financial institutions’ risk management strategies to mitigate transition risks and incorporate these risks within the supervisory time horizon, and result in a truer reflection of climate-related financial risks within the prudential framework.

If prudential transition plans are to be integrated into the prudential framework, it must be done in a manner that is proportional to the risks faced by financial institutions. This means accounting for the size of financial institutions and the threat they pose to financial stability, as well as their exposures to transition-sensitive sectors and overall transition risks.

The reporting of transition plans could be integrated into several tools within the supervisory and prudential toolbox, including the large exposures framework, stress testing, risk management under the Basel Framework Pillar II, and disclosure under Pillar III.

Climate-related systemic risks and macroprudential policy

Climate change has a clear systemic dimension: its consequences are not only widespread across all sectors and regions, but potential concentrations, spillovers and interlinkages within the financial system risk further amplifying its economic and financial impacts. The systemic nature of climate change for financial stability suggests the need for a macroprudential response that goes beyond a (microprudential) focus on individual firms and ensures a consistent approach across the financial system.

While climate change may be predictable, the timing of its financial impacts is uncertain. Therefore, central banks and financial supervisors must rapidly develop sound risk management practices adapted to a context in which policy decisions rely on imperfect data and high uncertainty.

Existing macroprudential policy toolkits can be deployed now to address climate-related systemic risks with some possible adaptations to reflect the unique features of climate-related risks, like the long time horizon over which they may materialise, their strong dependency on the speed and direction of the low-carbon transition, and the specific data and forward-looking measurement methodologies required to manage them.

Two possible instruments that can be tailored to address systemic climate-related financial risks are: (i) ‘systemic risk buffers’, to increase the resilience of the financial system to climate-related shocks and contribute to mitigating the build-up of future risks; and (ii) measures limiting exposure concentrations, which could target and thereby mitigate sources of risk where they are greatest. While there are undeniable challenges in devising these macroprudential responses to climate-related systemic risks (e.g. modelling complexity and uncertainty, partial data coverage), the risks will only increase with inaction. This points to the need for central banks and financial supervisors to adopt a forward-looking approach and progressive deployment of policy in their response to climate risk.

Using green credit policy to bring down inflation: what central bankers can learn from history

Central banks typically associate climate-supporting measures with an expansionary monetary policy stance. Accordingly, such measures are thought to be inappropriate in an inflationary context. Against this view, we highlight a longstanding tradition in central banking which held the contrary: it is desirable to protect some sectors during a tightening cycle because certain types of investment prevent, rather than cause, inflation. This view is informed by examples of policy that was made at the German Bundesbank and other central banks, and made in ways that were entirely compatible with economic liberalism and central bank independence.

There are several reasons for central banks to use green credit policy in an inflationary context. First, a lack of sufficient green investment is undesirable in terms of ensuring long-term price stability. Second, the high upfront costs associated with renewable energy production and infrastructure makes them particularly sensitive to interest rates. Third, monetary policy that seeks to bring down inflation in the short term by restricting investments in climate mitigation would make the global economy more vulnerable to future climate- and biodiversity-related economic shocks, including adverse shocks to price stability. Fourth, a lack of green investment would also expose the domestic economy to stronger price shocks to high-carbon energy or other goods whose production is affected by ecological transformation. Fifth, the failure of central banks to consider the environmental impact of their instruments can undermine the broader role for monetary policy in supporting financial stability, government economic policy, stable employment and other central bank objectives.

Giving priority to certain investments through targeted central bank refinancing is compatible with central bank independence and current mandates. It will, however, require more coordination with regard to other aspects of credit policy (e.g. sustainable finance taxonomy, financial regulation, public development banks), and a change in central bank accountability and communication with the public. There are many institutional arrangements to ensure both the effectiveness of central bank measures and their democratic legitimacy.

Inclusive green finance: A new agenda for central banks and financial supervisors

Climate change and environmental degradation can have profound economic impacts, which may translate into micro- and macro-financial risks that need to be addressed by central banks and financial supervisors. Green finance and financial inclusion have mostly been treated by central banks and financial supervisors as two distinct and largely unrelated agendas, despite meaningful overlaps between these two areas. Key target groups for financial inclusion tend to be disproportionately exposed to the impacts of climate change and environmental degradation, while also playing an important role in adapting to and mitigating environmental change.

Against this backdrop, central banks and financial supervisors can combine green finance and financial inclusion policies in an integrated inclusive green finance (IGF) approach. By accounting for equity concerns in the design of green policies, this policy approach can avoid any potential adverse effects on economically vulnerable groups, and enable central banks and financial supervisors to foster a just transition to an environmentally sustainable economy.

Central banks and financial supervisors have various tools at their disposal to translate the concept of IGF into actionable policies. By bringing together the complementary aims of green finance and financial inclusion, they can help to improve the livelihoods of low-income households and the business prospects of micro, small and medium-sized enterprises (MSMEs) while simultaneously contributing to climate change adaptation and mitigation, minimising associated risks for the financial sector.

The instruments that central banks and financial supervisors can use to leverage IGF for climate change adaptation and mitigation can be divided into market-shaping [indirect] policies and direct interventions. A range of IGF policies have already been adopted by the banks and supervisors, and there are emerging examples of best practice.

Building blocks for central banks to develop nature scenarios

Models and scenarios are increasingly being adopted by central banks and financial supervisors as a tool to support the assessment of climate risks, but existing scenarios currently do not sufficiently incorporate broader environmental risks, such as nature-related risks, into such assessments.

Nature scenarios are used in models to describe plausible future developments of all elements of nature, the development of socioeconomic variables and policies, and the interactions between them. A significant drawback is that outputs from nature–economy models and scenarios cannot readily be used by the financial sector.

In reviewing a selection of models currently used in economic and nature loss assessments, this briefing identifies five key issues for model and scenario development: input data needs; model assumptions; uncertainty around nature–economy interactions; the choice of global or local scenarios; and usability for financial institutions. While there are ways to address some of these challenges, more research is required to operationalise the solutions.

Overcoming these challenges could enable the introduction of more targeted monetary policies and prudential policies, and more effective financial sector risk management. It could also contribute towards shifting financing away from nature-harming investments.

Supporting the just transition: a roadmap for central banks and financial supervisors

Shifting to a sustainable economy will reshape the outlook for countries and sectors across the world. Managed well, the net zero transition could lead to more and better jobs as well as reduced risks from climate shocks. Managed poorly, however, it could result not only in stranded assets but also stranded workers and communities – and even stranded countries. In response, government policymakers have stressed the necessity for a ‘just transition’ that leaves no one behind in this process of change.

This objective requires action across all policy fields, including financial and monetary policies. A growing number of commercial banks and institutional investors are starting to incorporate just transition considerations into their climate strategies. Until recently, central banks and financial supervisors have focused their attention on the first order climate risks that confront financial systems and institutions. They have tended not to set out how they can respond to the social risks of decarbonisation and what they could do to support a just transition. However, there are emerging signs that central banks are starting to recognise the just transition agenda.

This paper sets out why it is important for central banks and supervisors to take an active role in supporting the just transition. It suggests a roadmap containing three steps – assessing, advising, and acting – for them to achieve this goal and explores some concrete policy options for aligning monetary policy operations and financial regulation with the imperative of a just transition.

Beyond climate: addressing financial risks from nature and biodiversity loss

There is increasing evidence that central banks and supervisors need to expand their environmental agendas beyond climate change. Globally, the richness and diversity of nature has declined at unprecedented rates over recent decades, posing far-reaching systemic risks for the financial sector.

The impacts of biodiversity loss call for urgent and transformative changes to economic and financial systems. This requires central banks and supervisors to collaborate with other policymakers to determine how the financial sector can manage nature-related financial risks, including how climate change and biodiversity loss interact. While only a limited number of policy tools have been developed to date, there are a range of options for integrating nature and biodiversity loss considerations into existing policy frameworks. These include updates to microprudential policies and disclosure requirements, and the use of macroprudential assessments and scenario analysis.

Building on the work of the NGFS-INSPIRE study group on Biodiversity and Financial Stability, this paper discusses the theoretical and practical need to extend the scope of central banks’ approach to the environmental crisis beyond the current focus on climate change implications to also include the drivers of biodiversity loss, the climate–biodiversity nexus, and the transmission channels of nature-related risk.

Greening capital requirements

Capital requirements play a central role in financial regulation and have significant implications for financial stability and credit allocation. However, in their existing form, they fail to capture environment-related financial risks and act as a barrier to the transition to an environmentally sustainable economy.

This paper considers how capital requirements can become green and explores how green differentiated capital requirements (GDCRs) can be incorporated into financial regulation frameworks.

Environmental issues can be incorporated into capital requirements using three different approaches: (i) microprudential approaches, which suggest that capital requirements need to be adjusted based on micro-level exposures to environmental risks; (ii) weak macroprudential approaches, which emphasise financial institutions’ exposure to systemic risks linked to specific sectors and geographical areas; and (iii) strong macroprudential approaches, whereby systemic risks are analysed through explicit consideration of macrofinancial feedback loops and double materiality. The use of microprudential and weak macroprudential tools can lead to an increase in physical risks at the system level – for example by undermining climate-vulnerable borrowers’ access to climate adaptation finance. According to strong macroprudential approaches, financial regulators should adjust capital requirements in a way that incentivises banks to support the ecological transition and economic resilience to climate change.

Green differentiated capital requirements (GDCRs), which can take the form of a green supporting factor (GSF) and a dirty penalising factor (DPF), are one of the tools that are consistent with the strong macroprudential approach. They can reduce physical risks, but they might have adverse transition effects if used in isolation. In the age of environmental crisis, strong macroprudential tools should play a prominent role in the greening of capital requirements. They need to be utilised in a way that is complementary with microprudential and weak macroprudential tools to minimise unintended adverse effects. If designed to accurately capture the environmental footprint of bank assets and minimise adverse financial side effects, GDCRs can contribute to the greening of the banking system and the reduction of systemic environmental risks. The positive effects of GDCRs can be enhanced if they are combined with other financial and non-financial environmental policy tools.

Greening collateral frameworks

Central bank collateral frameworks play a powerful role in contemporary market-based financial systems. Collateral rules and practices affect the demand for financial assets by financial institutions, with significant implications for governments’ and non-financial corporations’ access to finance. However, existing collateral frameworks lack environmental considerations and suffer from a carbon bias: i.e. they create disproportionately better financing conditions for carbon-intensive activities.

Environmental issues can be incorporated into collateral frameworks in a number of ways, notwithstanding various methodological and data challenges. We distinguish between (i) the environmental risk exposure approach, whereby credit assessments in collateral frameworks are modified to capture the exposure of financial institutions and central banks to climate-related financial risks, and (ii) the environmental footprint approach, in which haircuts and eligibility are adjusted based on the environmental impacts of financial assets. The two approaches have differing implications and design requirements.
We argue that the environmental footprint approach should be at the core of central banks’ green transformation of collateral frameworks. This approach contributes directly to the decarbonisation of the financial system, faces fewer practical challenges than the environmental risk exposure approach and does not penalise companies that are exposed to physical risks. It is also conducive to the reduction of systemic physical financial risks.

Central banks have a crucial role to play in developing a framework that will accelerate the collection and harmonisation of environmental data associated with financial assets. This will not only help to successfully decarbonise the assets of non-financial corporations included in the collateral framework but will also allow the expansion of greening to other asset classes, such as covered bonds, mortgages, corporate loans and asset-backed securities.