The exposure of financial institutions to risks from a transition to a low-carbon economy

This workshop shall address some of the limitations in current modelling approach, with a focus on transition risks. The programme will be divided into two consecutive sessions: Session I focuses on scenario applications for evaluating transition risks for financial institutions and Session II is orientated around scenario calibration and modelling methodologies.
Contributions from: Gregor Semieniuk – UMASS;
Rick Van Der Ploeg – University of Oxford;
Edo Schets -Bank of England;
Stephane Dees – Banque de France;
Ulrich Volz – SOAS
Stefano Battiston – UZH
David Carlin – UNEP-FI
Maarten Vleeschhouwer -2 Degrees Investing Initiative
Christophe McGlade – IEA
Christoph Bertram – PIK
Massimo Tavoni – PoliMi), Alex Koberle (Imperial College London), James Edmonds (PNNL), Michael Grubb (UCL) and Jean-Francois Mercure (University of Exeter)

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.

 

Supervision beyond the business cycle: A framework for long-term financial supervision

Financial supervisory mandates are interpreted to ensure financial stability ‘over the business cycle’ (three to five years). New risks are challenging this paradigm, as they manifest themselves both over longer time horizons and as secular, one-directional shocks. We have designed this exploratory conceptual project to identify potential mechanisms and levers financial supervisors can mobilise in order to ‘supervise the long-term’ and reframe their mandate to cover more long-term risks.

Current financial policy and supervisory analysis falls into two categories. In the first category, financial policy analysis seeks to identify potential levers within the mandate to supervise risks over the business cycle (e.g., capital requirements) or support societal goals. The second category involves the development of tools to analyse the financial materiality of long-term risks (e.g., climate scenario analysis). Missing within this paradigm is the ‘adapter’ that allows for the integration of the second category of analysis into mainstream supervisory frameworks. As a result, stress tests looking out to 2030 are intellectually satisfying, but remain largely theoretical exercises.

We seek to begin to fill this gap by suggesting a framework for what long-term financial supervision could look like that would allow for the integration of these long-term risk assessments, as well as the steering of policy levers beyond business cycle risk management. This requires a review of both existing and potential new policy instruments, as well as more general questions over how such policy could work (including related to the arbitrage between short-term and long-term risks).

The primary output of our research will be a discussion paper focused on two central questions:

  • What are the instruments to enhance the supervision of long-term risks?
  • How might governance and mandates need to change to support the supervision of long-term risks?

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.

Prudential instruments to scale up green finance: simulating the impact of green prudential regulations in an agent-based macro-financial model

The existing financial regulatory framework made notable progress in detecting, assessing, and containing systemic risks. However, a closer investigation of existing prudential instruments shows that several regulations under Basel III contain an intrinsic ‘carbon bias’ that creates barriers to aligning the financial sector with sustainable transition roadmaps. In particular, on the one hand, existing capital and liquidity regulations underestimate the risks related to so-called ‘green assets’ and potentially undermine the resilience of the financial system. On the other hand, they limit the bank capital available for green assets and favour dirty assets.

By considering the current state of the art, we highlight the lack of a comprehensive framework that is needed to analyse the impact of green prudential regulations. Thus, our research project aims to build such a framework and study how prudential regulations could deal with risks to financial stability arising from climate change. By building on theoretical research we have published in the past, this project aims to develop a tool to assess the implications of the implementation of different green prudential instruments under different macrofinancial scenarios. We will resort to the agent-based modelling approach (to build up a macrofinancial model) populated by a heterogeneous production sector, heterogeneous consumers, a banking sector, and a central bank.

This research will help in understanding, on the one hand, whether climate-related macroprudential tools lead either to market distortions or financial instability. On the other hand, it could assist in detecting which are the main factors that hinder or contribute to the effectiveness of such instruments.

Assessing forward-looking climate risks in investors’ portfolios: from theory to practice

Climate-related financial risk is characterised by endogeneity and deep uncertainty. The inadequacy of standard financial risk approaches to deal with these dimensions is a challenge for a smooth transition to a low-carbon economy. Across the last five years, we have developed a stream of work addressing this issue using a framework for climate financial risk management under uncertainty. This framework has been applied to the analysis of climate risk of financial portfolios, in collaboration with financial supervisors.

With this project, we aim to mainstream such a framework in microprudential and macroprudential policies implemented by financial supervisors and financial institutions belonging to the NGFS. We have engaged with relevant NGFS stakeholders through bilateral meetings, focus groups, and international conferences to co-develop narratives related to two main questions:

  • How can the available scientific knowledge on climate change mitigation be best applied to identify relevant scenarios of disorderly low-carbon transition?
  • What are the implications of scenario selection for investor decisions and for financial stability?

We found there is great importance to foster central banks’ and financial regulators’ understanding about:

  • Climate change mitigation scenarios (e.g., those co-developed and used by the NGFS), their limits and opportunities, and the conditions to use them to inform climate stress tests exercises;
  • The endogeneity of climate-related financial risks in climate stress test; and
  • The conditions for finance to be a driver or a barrier to the transition.

The stochastic impact of extreme weather events

In this project, we assess the impact of abnormal weather shocks on the global macroeconomy. Extreme weather events are random in size and location. We use stochastic trials to generate a distribution of weather shocks across the world and use NiGEM, a large macroeconometric model, to quantify the impact of these shocks on the macroeconomy. NiGEM links countries through trade and non-trade channels, and as such, a shock that impacts a single country or region will reverberate to other parts of the world. Our project captures the direct and the indirect impact of extreme climate events. Our analysis shows that extreme weather events cause economic volatility and that spillover effects magnify these events. We show that international spillover effects from trade and financial markets are important transmission channels, particularly for small open economies that are densely populated.

Our research has implications for at least two areas of central bank policy. The most proximate area of intervention is through the stress-testing framework where financial institutions should, in our view, disclose the risks posed by extreme weather events. Central banks can also adjust capital buffers to specifically account for assets that are exposed to such events and intervene in a more granular way using lending metrics such as the loan-to-value ratio. Second, where possible, the central banks can adjust the haircut imposed on the collateral that it accepts in its monetary policy refinancing operations by taking into account the financial risk posed by extreme weather events.

Low-carbon Transitions and Systemic Financial Risk

The transition to a low-carbon economy has been cited by policymakers as a potential driver of systemic risk that could lead to financial instability and negative macroeconomic outcomes. Most notably, Mark Carney’s ‘Tragedy of the Horizons’ speech warned of the potential of a transition-driven ‘Minsky moment’ whereby a disorderly process leads to a sudden collapse in asset prices.

We identify the channels through which a transition shock could lead to a systemic disruption. These include the downward repricing of carbon-intensive (or green) assets and a reduction in emissions-intensive production. We outline the approaches developed by existing studies to assess systemic risk, including the tracking of transition risk indicators such as bank exposure to emissions-intensive sectors, stress-testing frameworks, and network modelling approaches.

There is still much uncertainty on how to best measure the level of systemic risk posed by the transition, and therefore the size of this risk. Paradoxically, the realisation of systemic risks is more likely when the source of risk is not well understood. It is therefore important to consider the possible channels and work on their potential implications.