WHY IT MATTERS
What is at stake
From unprecedented forest fires in the US and bushfires in Australia, to heatwaves in the Arctic, historic floods in China and Bangladesh, and to rising sea levels and collapsing fish stocks, the consequences of climate change and environmental degradation are already having profound socio-economic impacts, and are worsening.
These translate into material risks for businesses. The physical impacts of climate change, from extreme weather events to gradual changes in weather conditions or sea level rise, can affect property value, disrupt supply chains, and dramatically affect the livelihoods of hundreds of millions. Transition risks, brought about by abrupt or gradual changes in regulations or consumer behaviour, can create stranded assets, particularly in the carbon-intensive sectors such as those reliant on coal, oil & gas. There are also increasing liability risks, as concerned citizens are taking public and private institutions to court over compensation for historical climate damage or over insufficient actions to mitigate climate change.
While a lot of attention has been paid to climate-related risks, the unsustainable use of natural resources is a similarly urgent issue to address. The erosion of key ecosystem services such as pollination, air and water purification, pest and disease control, or climate regulation, is putting our livelihoods at risks. Healthy and functioning ecosystems also act as a natural defence against extreme weather events that are amplified by climate change. These complex interactions between people, the climate, and nature, are illustrated in the opposite figure, taken from WWF’s Climate, Nature and our 1.5°C Future - A synthesis of IPCC and IPBES reports (December 2019).
Despite growing awareness of the risks associated with climate change and environmental degradation, our collective efforts have so far been insufficient. The world is not on track to meet the global objectives of the Paris Agreement, and to reverse the loss of nature.
A more concerted and focused effort is required to address these existential threats and reap the massive opportunities brought by transitioning to more sustainable and resilient business models, in a manner that is also just and equitable.
The financial sector plays a key enabling role in this transition, by channelling financial flows away from activities incompatible with our global objectives and towards activities that contribute to a sustainable future.
The role of central banks and supervisors
While governments are primarily in charge of setting national policies on environmental and social matters, and of creating the right frameworks of regulations and incentives for the public and private sectors, financial regulators and central banks also have a very important role to play in addressing risks and steering financial flows towards the desired outcomes.
Indeed, they are uniquely positioned to influence the lending and investment practices of financial institutions, as well as their disclosure practices. This can be achieved through various means, from setting expectations around governance and risk management processes, mandating scenario analysis that quantify exposure to climate-related risks, to imposing specific disclosure requirements or setting differentiated capital requirements, to name a few. Regulators and central banks also play an advocacy role, and are making it increasingly clear that climate-related and environmental risks are a source of financial risks and, if left unchecked, of increasing financial instability.
The Network for Greening the Financial System (NGFS), a growing group of central banks and supervisors determined to join forces in addressing the risks brought by the climate and environmental emergency, and to scale up green finance, has produced numerous reports providing guidance to the central banking and supervisory community on a wide range of topics from setting supervisory expectations to designing forward-looking scenarios for climate-related stress testing. A report published by the NGFS in September 2020 provides an overview of transmission channels from environmental and climate-related risks to micro- and macro-economic impacts and financial risks, as depicted in the figure below.
Source: Overview of Environmental Risk Analysis by Financial Institutions (NGFS, September 2020)
While the specific mandates of central banks and financial supervisors may vary across countries, their key responsibilities usually include controlling inflation and money supply, ensuring financial stability and the safety and soundness of financial institutions. To do so, they can leverage on a wide range of tools and measures, from monetary policy to macroprudential and microprudential supervision.
As climate-related and environmental risks are having structural impacts on the economy and the financial system, central banks, financial regulators and supervisors have started to take action.
The highlights below are just a few examples of key recent developments and actions from central banks and financial supervisors that contribute to shaping a more sustainable financial system across the world.
The Bank for International Settlements (BIS) and Banque de France issued The Green Swan: Central Banking and Financial Stability in the Age of Climate Change (January 2020). This report explores ways to address climate-related risks within central banks’ financial stability mandate.
The BIS referred to climate-related risks as ‘green swans’, or “potentially extremely financially disruptive events that could be behind the next systemic financial crisis”.
It recognized the role and responsibility of central banks, but also the need for “coordinated actions among many players including governments, the private sector, civil society and the international community”.
The Basel Committee on Banking Supervision established in 2020 a high-level Task Force on Climate-related Financial Risks, charged with contributing to the Committee’s mandate of enhancing global financial stability by undertaking several initial initiatives including a stocktake of members’ existing regulatory and supervisory practices, a series of analytical reports on transmission channels and the development of effective supervisory practices to mitigate climate-related financial risks.
In the European Union, the implementation of the European Commission’s Sustainable Finance Action Plan led to a number of landmark developments. In June 2020, the Taxonomy Regulation was officially published, following the release of the final report and its technical annex in March 2020. In June 2021, a first delegated act was adopted to define eligible activities under the climate change adaptation and mitigation objectives. Another delegated act was issued in July 2021 to specific disclosure obligations for financial and non-financial corporates.
The Taxonomy is a tool which helps investors and companies to make informed investment decisions based on the compatibility of economic activities with the EU’s sustainable development objectives, which include being carbon-neutral by 2050.
The first set of screening criteria has been issued for activities that significantly contribute to climate mitigation or adaptation. Such activities should also comply with minimum social safeguards and avoid significant harm to other EU objectives (sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention control, and protection and restoration of biodiversity and ecosystems).
The taxonomy will form the backbone of disclosure requirements and the EU Green Bond Standard, and is expected to create a common language for financial institutions and corporates, to limit risks of greenwashing, and to direct financial flows towards activities that meaningfully contribute to a low-carbon and resilient economy.
In China, the China Banking and Insurance Regulatory Commission (CBIRC) was one of the first regulators worldwide to issue regulations related to sustainable banking, with the Green Credit Guidelines published in 2012.
The guidelines regulate green credit and E&S risk management practices for the banking sector, and were complemented in 2014 by a detailed set of key performance indicators (KPIs). The 21 largest banks have to annually submit the results of their self-assessment against those KPIs to the CBRIC.
In May 2020, the People’s Bank of China issued a revised “Green Bond Endorsed Project Catalogue” for public consultation. This new catalogue harmonizes standards and practices for green bonds in China, by replacing previous standards adopted by other government agencies. Importantly, the revised catalogue no longer contained references to certain controversial fossil-fuel related activities (incl. the ‘clean’ utilization of coal). The final version has been published in April 2021.
In the United Kingdom, the Bank of England (BoE) has taken a leadership role on climate change. Since Mark Carney’s “Breaking the tragedy of the horizon—climate change and financial stability” speech at Lloyd’s of London in September 2015(*), the central bank has issued a number of key reports and participated in international efforts to highlight climate-related risks to the financial system.
In April 2019, the Prudential Regulation Authority published its supervisory expectations for banks and insurers to manage the financial risks from climate change, covering governance (incl. at the board level), risk management, the use of scenario analysis, and disclosure aspects.
In 2021, the BoE will perform a climate stress test of the UK financial sector (focusing on banks and insurers), as part of its Biennial Exploratory Scenario exercise. This will test the resilience of the financial sector, based on a range of scenarios and building on the work undertaken by the NGFS. As part of its multi-stakeholder approach, the BoE issued a discussion paper for public consultation in December 2019.
The BoE also expects that by 2022, financial institutions and listed corporates will be disclosing in line with the recommendations of the Task Force for Climate-related Financial Disclosures (TCFD).
(*) Mark Carney was then Governor of the Bank of England (until March 2020) and Chairman of the Financial Stability Board (until December 2018), and is now the UN Special Envoy on Climate Action and Finance.
In Brazil, the Banco Central do Brasil (BCB) passed a resolution in 2014 making it mandatory for financial institutions to establish a Social and Environmental Responsibility Policy to manage E&S risks.
Importantly, such policy should be backed by the appropriate governance arrangements, including with a senior representative responsible for ensuring a proper implementation of the policy.
This was complemented by a further circular issued in 2017, requiring banks to take into account their exposition to E&S risks in their internal risk assessment process and in the calculation of their capital adequacy, to ensure that banks are sufficiently resilient and able to withstand shocks related to such risks.
In Singapore, the Monetary Authority of Singapore (MAS) has launched its Green Finance Action Plan in November 2019, aiming to strengthen the resilience of the financial sector in Singapore, and to position the country as a leading centre for sustainable finance in Asia and beyond.
Among the range of new measures, the existing green bonds grant scheme was expanded to cover also social and sustainability bonds. The scheme encourages the issuance of green, social and sustainability bonds in Singapore by covering the additional costs incurred by issuers to conduct external reviews in line with internationally-recognised standards and frameworks.
In December 2020, MAS issued the Guidelines on Environmental Risk Management, setting its supervisory expectations for enhanced governance, risk management and disclosure practices by banks, asset managers and insurers operating in Singapore. This was followed by the publication of a Handbook on Implementing Environmental Risk Management by the Green Finance Industry Taskforce (GFIT), convened by MAS and comprised of representatives from financial institutions, corporates, non-governmental organisations, and financial industry associations.
In the Netherlands, De Nederlandsche Bank (DNB) has published a range of landmark reports assessing the financial sector’s exposure to a range of E&S risks, while providing recommendations for financial institutions to better manage those risks.
The ‘Waterproof?’ report (2017) looked at climate-related physical and transition risks, with a focus on insurers, impacts flood risk on various parts of the financial sector, exposure to carbon-intensive sectors, and the emergence of green finance. In 2018, this was complemented by an energy transition risk stress-test exercise based on four scenarios and applied to Dutch banks, insurers and pension funds.
The ‘Values at Risk’ report (January 2019) looked at exposure of 25 Dutch banks, insurers and pension funds to water stress, biodiversity loss, raw material scarcity and human rights controversies. This was complemented in June 2020, by the ‘Indebted to nature’ report, which delves deeper in the various types of risks related to the loss of biodiversity, and the extent to which the Dutch financial sector is exposed to them.
DNB is also chairing the Network for Greening the Financial System, and its governor Frank Elderson has been a prominent voice within the central banking community and beyond, advocating for a better consideration of the financial risks associated with climate change and nature loss.
In Malaysia, the financial regulators have started to take key steps to build a sustainable and resilient financial sector. Bank Negara Malaysia (BNM) and the Securities Commission Malaysia (SC) established the Joint Committee on Climate Change (JC3) in September 2019.
Also composed of senior officials from Bursa Malaysia and financial institutions operating in Malaysia, the JC3 is tasked with building capacity in the management of climate-related risks, identifying issues and priorities in managing the transition towards a low carbon economy, and facilitating collaboration between stakeholders.
In November 2019, BNM issued the Value Based Intermediation Financing and Investment Impact Assessment Framework (VBIAF) for Islamic financial institutions to incorporate E&S risk considerations in their risk management system. Other commercial financial institutions were encouraged to use the VBIAF for their own operations.
In a further key development, BNM published its Climate Change and Principle-based Taxonomy in April 2021, following a public consultation phase. The document aims to serve as a “guidance to facilitate financial institutions in identifying and classifying economic activities that could contribute to climate change objectives”.