Projects: CFR1-JRC

NGFS-GRASFI-INSPIRE exchange – Climate-related financial policy in a world of radical uncertainty

Josh Ryan-Collins (University College London) will present his research “Climate-related financial policy in a world of radical uncertainty – towards a precautionary approach” co-authored with Hugues Chenet (University College London) and Frank van Lerven (New Economics Foundation).

The NGFS-GRASFI-INSPIRE exchange is designed to strengthen the connection, collaboration and research exchange between the central bankers, financial supervisors and the academic community to share and explore new and innovative research that advances the agenda on greening the financial system. New editions occur monthly and are co-organised by the NGFS Secretariat, INSPIRE and GRASFI (the NGFS’ two designated global research stakeholders). This 2nd edition is hosted by INSPIRE.

 

Climate-related Financial Policy in a World of Radical Uncertainty: Toward a Precautionary Approach

Climate- and environment-related financial risks, both transition and physical, are characterised by radical uncertainty. This means conventional backward-looking probabilistic financial risk modelling is not fit for purpose in dealing with this uncertainty. While scenario analysis and stress testing to some extent recognise the uncertainty problem, they remain based on assumptions that are subject to significant uncertainty and do not sufficiently justify action in the short term, despite widespread recognition of the risks posed by inaction.

To address this lack of certainty, we have proposed the adoption of a new policy framework, the Precautionary Financial Policy (PFP) approach, to deal with the financial stability risks. This framework draws on two well established concepts: first, the ‘precautionary principle’ commonly adopted in environmental management policies to avoid passing certain thresholds, and second, modern macroprudential policy. PFP justifies fully integrating climate- and environment-related financial risks into financial policy, including both prudential and monetary policy frameworks. This helps to justify preventative actions now in order to mitigate the potentially catastrophic financial and economic damages created by climate change, and shape financial markets in a clear direction toward a preferred net-zero carbon future.

In terms of implementation, we propose the comprehensive integration of climate risk into capital adequacy requirements, monetary policy operations (including asset purchases and collateral criteria), quantitative credit controls and credit guidance, and the enhancement of financial system resilience. Policymakers adopting a precautionary approach should be aware of the likely short-term trade-off between efficiency and resilience, and likely resistance from market actors with shorter-term time horizons. There is a need to ‘learn by doing’ in this new environment.

Finance, climate-change and radical uncertainty: Towards a precautionary approach to financial policy

Climate-related financial risks (CRFR) are now recognised by central banks and supervisors as material to their financial stability mandates. But while CRFR are considered to have some unique characteristics, the emerging policy framework for dealing with them has largely focused on market-based solutions that seek to reduce perceived information gaps that prevent the accurate pricing of CRFR. These include disclosure, transparency, scenario analysis and stress testing. We argue this approach will be limited in impact because CRFR are characterised by radical uncertainty and hence ‘efficient’ price discovery is not possible. In addition, this approach tends to bias financial policy towards concern around avoiding short-term market disruption at the expense of longer-term, potentially catastrophic and irreversible climate risks. Instead, an alternative ‘precautionary’ financial policy approach is proposed that offers an intellectual framework for legitimizing more ambitious financial policy interventions in the present to better deal with these long-term risks. This framework draws on two existing concepts — the ‘precautionary principle’ and modern macroprudential policy — and justifies the full integration of CRFR into financial policy, including prudential, macroprudential and monetary policy frameworks.

Climate-related financial policy in a world of radical uncertainty: Towards a precautionary approach.

Climate-related financial risks (CRFR) are now recognised by central banks and supervisors as material to their financial stability mandates. But while CRFR are considered to have some unique characteristics, the emerging policy agenda for dealing with them has largely focused on conventional market-based solutions. The current policy emphasises information gaps that prevent the accurate assessment of market risk. The assumption is that these gaps can be remedied via disclosure, transparency, scenario analysis and stress testing, which will enable markets to self-correct. We argue this approach is misguided as CRFR are characterised by radical uncertainty and hence ‘efficient’ price discovery is not possible. Instead, a ‘precautionary’ policy approach is proposed. Since climate change poses a severe and potentially irreversible threat, a lack of scientific certainty as to its exact nature or timing should not prevent regulatory action to mitigate its impact. Such an approach justifies fully integrating CRFR into financial policy, including both prudential and monetary policy frameworks. Central banks and financial supervisors can and should actively steer market actors in a clear direction — towards a managed transition — to ensure a scenario that minimises harm to the financial system and the wider economy in the future.