Help central banks measure climate risk, says NGFS

NGFS was established by eight central banks and supervisors at the One Planet Summit, held in Paris in December 2017, with the aim of sharing best practices, contributing to the development of climate and environment‑related risk management in the financial sector, and mobilising mainstream finance to support the transition towards a sustainable economy. Eight has since grown to 66.

In April 2019, the NGFS published its first comprehensive report, A Call for Action, with recommendations on facilitating the role of the financial sector in achieving the objectives of the 2015 Paris Agreement​. In June last year, it presented three representative scenarios: Orderly - Early, ambitious action to a net zero CO2 emissions economy; Disorderly - Action that is late, disruptive, sudden and/or unanticipated; and, Hot house world - Limited action leads to a hot house world with significant global warming and, as a result, strongly increased exposure to physical risks.

Limitations of snapshots

Its reference scenarios are "one of the biggest deliverables" of the NGFS for greening the financial system, but like all scenarios they have their limitations, Després said, because being able to measure, rather than simply describe, climate risk is crucial.

"Usually people take a snapshot of the current exposures, using some disclosure practices, but it only gives you a backward looking approach. You don’t really know how the exposures are going to evolve over the next 5, 10, 15 years," he said.

What is needed instead, he said, are specific scenarios that include financial information, data and hypothesis, macroeconomic analysis, and also non-financial data and analysis of climate science and energy science.

"It's not our job as central banks to develop that expertise, and so we work closely with a consortium of scientists who built the NGFS scenarios, which are not forecasts, but possible pathways to a low-carbon transition," he said.

These must show banks two things.

"Firstly, what we want to know, in a medium-term perspective, is what the impact is going to be; to see to what extent banks and insurance companies' balance sheets are exposed to climate risk, and to measure those exposures in a forward looking approach.

"And also we want to measure how, in a dynamic manner, banks, insurance companies and financial actors in general will change the allocation of their portfolio to hedge climate risk, or to make it more aligned to a low-carbon economy."

NGFS is not yet at the stage where it can create banking policy measures on climate risk, he said, but it will be releasing an updated version of its scenarios in the next few weeks.

Measurements

"There are a number of things we need to measure. For example, we have definition issues, taxonomy issues, data issues, but the ultimate objective is to use those scenarios so that authorities may say that, 'This bank,or this insurance company, is particularly exposed to climate risk, and is not taking the right measures to mitigate the risk, so they've got to do something about it'," Després said.

"That may be policy measures to do with disclosure but, ultimately, we may imagine some measures that have to do with capital requirement. At this stage it's still a far and remote prospect, but I suspect the objective is to take those scenario analyses on board and to use them as a mainstream supervisory tool."

The conference was moderated by Sama Bilbao y Léon, director general of World Nuclear Association, who asked whether and how banks can steer investment decisions for a low-carbon economy.

"There are many things that we can do and there are many things we can't do," Després said, and that is because the understanding of what a bank's 'mandate' means is changing.

Stability

Central banks are confined by their mandate because many of them are independent from the state, and therefore politics, but there are still actions they can take.

"My feeling is that, within the central banking and supervisory community, there is now a very wide consensus that climate risk is a risk in terms financial stability, so within the financial stability mandate of central banks there are many things that we can do," he said. These include a scenario analysis campaign and, later, the introduction of regulatory measures in terms of disclosure, for example.

They can also do a specific monitoring of the financial system to measure whether the exposures are growing and where the risk is located, he said, adding that, "It's pretty much understood everywhere that we have to do something within our financial stability mandate."

Beyond that is the question of risk in terms of price stability, which is "a new frontier" in the central banking community, he said.

"A few years ago, if you had invited me to, I would never have even uttered the phrase 'monetary policy' because it was completely taboo to say there would be any kind of relationship between climate change and price stability, or monetary policy. Now things are changing.

"A growing number of researchers, but also policy analysts, are finding out that, in a hotter world, more frequent extreme [weather] events could have an impact on money supply, on inflation targets, on monetary policy indicators. Ultimately, if you want to do your job properly, you need also to include those within your price stability mandate, and you need to start reflecting around ways to introduce that into your monetary policy framework as well."

Early next week, the NGFS is going to release a report on this topic to explore how in practice central banks can reflect climate risk in their various monetary policy instruments, such as their collateral framework and purchase programmes, he said.

Another topic being explored is a bank's reserve portfolio, which for some central banks is "massive".

"The right thing to do is to practise what we preach and to walk the talk, and to say that, if you are a central bank, then you tell your banks that they have to take care of climate risk, to measure it, to mitigate it and also to reflect it in your own investment practices."

For example Banque de France last year published a report that disclosed its exposure to "the brown industries", he said. This year, the bank will "go one step further" and start introducing some exclusion from coal investments.

"We're doing that in our non-monetary portfolio because the Banque of France is in the Euro system and so we don’t have full control over the monetary policy portfolio. For that reason, we wanted to introduce them in our non-monetary portfolio over which we have full control," he said.

"As I said, there are many things we can do on financial stability mandate, price stability mandate, non-monetary portfolio in order to 'walk the talk', and if all central banks were doing this, I suspect it would already be a very big leap forward. This is what we're trying to promote within the NGFS."

Colour continuum

Després stressed that central banks and supervisors "don't want to be prescriptive" because determining whether an activity or sector is "green or brown" is a political decision. What they need, he said, is a colour-coded measurement scale "from light green to dark brown".

"It's very useful for us to have this continuum of colours, including also a brown taxonomy because so far in the EU you have a so-called green taxonomy. If we want to do proper risk analysis, then we also need to know what to measure and currently there is no harmonised definition of what is non-green, if you like, and what is brown."

In the absence of such guidance, the banking community is having to "guestimate" what a clean transition activity or asset is, and what is not.

In addition to a scale based on colour, the banking community needs a measurement tool that is also dynamic, he said. "There might be some sectors that are not green now, but over time they will be greener and, ultimately, what we want to do is to prepare for the transition. We want to help some sectors, some technologies, some activities, to transition from where they are now to another place later. To do that, we need to be able to measure - but also to reward - in a way to progress towards a low-carbon economy."

Taxonomy

Asked by Bilbao y Léon about the prospect of a globally consistent taxonomy on sustainable finance, Després said this "seems quite difficult".

"At the end of the day, you have a lot of national specificities in the various taxonomies that are available right now. It reflects the variety of development, of allocation of resources, of energy mix, and so it makes sense that we will not have a single taxonomy for a while.

"But we do need to have clarity about what is in there and what is not in there. And investors need to know that when they invest in a green asset in a 'y' country, that it’s not the same 'green' as in an 'x' country. They need to provide clarity vis-à-vis their investors that, 'We can't invest in that green asset in that country because although it is green for them it isn’t green for us'."

Instead, there will probably be "a progressive, iterative approach", he said, starting with definitions that are comparable and transparent. This could lead to a two-tier approach, with a single core element of taxonomy and specific regional or national "blocks" built on top of it, he said.

COP26

Asked about the role central banks will play at the next round of UN climate talks, he said: "We are working closely with the COP26 team on a number of common deliverables and clearly they are ambitious, which is excellent for the central banks, but also for the private sector at large.

"The role of development banks is vital because the private sector is ready to provide funding, but there is the problem of making those savings available to finance bankable or investible projects. There is the question of how you design, structure and de-risk some specific projects, and clearly multilateral development banks have a role to play. I'm pretty sure some of them are already working on proposals that will be released at COP26 in November."