International Network for Sustainable Financial Policy Insights, Research and Exchange

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.

Sustainable management of central banks’ foreign exchange (FX) reserves

Central banks are playing an increasingly active role in promoting the move towards a sustainable global economy. One key motivation is the need to mobilise funds for the large-scale public sector investment required to reach the goals of the Paris Agreement on climate change. This paper explores the role central banks’ foreign exchange (FX) reserves portfolios can play in this context. Central banks’ frameworks for managing FX reserves have traditionally balanced a triad of objectives: liquidity, safety and return. Incorporating sustainability requires expanding this usual triad into a tetrad. This can be achieved either explicitly, by introducing new economic uses of reserves, or implicitly, by recognising the ways in which sustainability affects existing policy objectives – or through a combination of both approaches. Pursuing sustainability, however, may give rise to trade-offs over and above the usual tensions between liquidity and safety and return. This paper explores sustainability-enhanced reserve management in the context of these trade-offs and outlines 12 different channels (classified into four different types) that reserve managers can use to ‘green’ their operations. Each of these channels comes with its own advantages and limitations, so – given the constraints faced at the individual reserve manager’s level – choosing the right channels is key

Aligning financial and monetary policies with the concept of double materiality: rationales, proposals and challenges

The concept of double materiality is developing rapidly, with potential implications for monetary and financial policies. Double materiality builds on the historical accounting and auditing convention of materiality and expands it by considering that non-financial and financial corporations are not only materially vulnerable to environment-related events and risks, but also materially contribute to enabling dirty activities and environmental degradation.

Three rationales that support the use of double materiality are distinguished in this paper, each with different policy implications: i) an idiosyncratic perspective – closely connected to the concept of dynamic materiality – which considers that an entity’s environmental impacts are relevant as they provide information on the institution’s own risks; ii) a systemic risk perspective – closely connected to the concept of endogeneity of financial risks – which seeks to reduce financial institutions’ contribution to negative environmental externalities because of the systemic financial risks that could result from them; and iii) a transformative perspective seeking to reshape financial and corporate practices and values in order to make them more inclusive of different stakeholders’ interests and compatible with the actions needed for an ecological transition. Each of these rationales has potential implications for monetary and financial policies, as well as possible theoretical and practical challenges.

While the adoption of a double materiality perspective remains an open question, the concept proposes the opportunity to think more comprehensively about the role of the financial system in urgently addressing the ecological challenges of our times.

This paper is part of a toolbox designed to support central bankers and financial supervisors in calibrating monetary, prudential and other instruments in accordance with sustainability goals, as they address the ramifications of climate change and other environmental challenges. The papers have been written and peer-reviewed by leading experts from academia, think tanks and central banks and are based on cutting-edge research, drawing from best practice in central banking and supervision.

Sustainable and responsible management of central banks’ pension and own portfolios

Central banks are increasingly looking to align their operations with sustainability objectives within the constraints of their mandates. This agenda mainly originated in central banks within the broader remit of financial stability, in their capacity as supervisors. However, some central banks have also begun to explore and act on the sustainability implications for their identity as managers of investment portfolios, including sustainable and responsible investment of their pension and own portfolios. The drivers for doing so range from managing sustainability-related risks to aligning their activities with wider government policies and commitments, including with net-zero emissions targets. This challenges the conventional approach that calls for investments to be guided by the trinity of objectives of ‘liquidity, safety and return’, which overlooks the value of an environmental, social and governance (ESG) approach as a means to identify risks and opportunities.

Yet central banks’ progress on this agenda to date has been relatively muted compared with their peers from the wider public investor community such as pension funds and sovereign wealth funds. Only a few central banks are signatories to the UN-supported Principles for Responsible Investment, have climate-related targets, or have made their responsible investment principles public. Low rates of adoption may be due to challenges relating to the availability of data, information and resources, to the particular characteristics of a typical central bank portfolio, or to issues of institutional independence and mandates.

Central banks can learn from their peers from the central banking community that are more advanced in this process, as well as from the wider public investor community in implementing sustainable and responsible investment through strategies including active ownership, ESG integration, impact investing, screening and thematic investing. This paper identifies a recommended course of action for central banks in sequence across the different phases from developing and implementing relevant policy, to monitoring and reporting outcomes, to identifying further adjustments to the policy and its implementation.

Central banks and climate-related disclosures: applying the TCFD’s recommendations

Central banks are increasingly exploring how climate-related financial risks and opportunities impact their price and financial stability mandates, as well as their own operations. They are also beginning to consider how their own actions, and those of the financial institutions they supervise, may contribute to and exacerbate climate change risks and opportunities.

Measuring and reporting – or disclosing – climate-related risks and opportunities is a key step in addressing these issues, for both individual institutions and the financial system as a whole. With this recognition, the Task Force on Climate-related Financial Disclosures (TCFD) was established, to guide financial institutions to make effective climate disclosures. The development of high quality, reliable, comparable and transparent climate disclosures can support decision-making and enable better understanding of the implications of climate change for central banks. Further, central banks can lead by example by demonstrating lessons learned from their own climate-related disclosures to other financial institutions and by using their influence over the financial rulebook to build the broader system architecture.

This paper reviews key elements of the recommendations made by the TCFD – first released in 2017 – and their application by central banks to date. The paper also considers potential enhancements for central banks’ climate disclosures and their possible implications for the wider financial system. The fact that definitions, data, and methodologies for assessing climate-related issues are constantly evolving means that efforts to develop climate-related disclosures will need to follow a progressive approach, with the quantity and quality of disclosures improving in parallel with the progress made in these areas. A flexible framework also suits the distinct operational models and different mandates of central banks.

The recommendations made in this paper can be applied to the different central bank portfolios, including monetary and non-monetary and credit facilities, as well as financial stability and physical operations. They are designed to support a wider and more practical application of the TCFD recommendations by central banks.

Developing a precautionary approach to financial policy – from climate to biodiversity

Climate change and biodiversity loss have primarily been approached by financial authorities (central banks and supervisors) from the perspective of financial risk. The prevailing view is that there is insufficient information and understanding of environment-related financial risks within financial institutions. If such financial risks can be discovered, measured and disclosed, they can be priced into financial markets to support a smooth environmental transition and this market failure can be addressed.

However, environment-related financial risks have particular features that make them less amenable than other types of risk to standard financial risk management approaches. In particular, the ‘radical uncertainty’ characterising the long time horizons and the endogenous and non-linear dynamics involved with environmental change make quantitative calculations of financial risk challenging, if not impossible.

The authors propose in this paper an alternative, precautionary approach to financial policy, incorporating both prudential and monetary policies. As a framework it draws on the ‘precautionary principle’ and modern macroprudential policy traditions. A precautionary financial policy mindset acknowledges the importance of measurement practices and price discovery but justifies bolder policy action to shift the allocation of capital to shorter time frames better aligned with the uncertain and potentially catastrophic nature of environment-related threats, including the risks to, and posed by, financial institutions. The paper considers financial authorities’ tentative steps and possible tools in such a precautionary policy direction – and how these could be scaled up and mainstreamed.