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.

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.