Updated: Nov 21
Author: Irene Fantappiè
Date of Publication: 24/10/2022
After decades of negligence towards the environment, it comes as no surprise that climate change is an incredible threat to our planet. If that wasn’t enough, in recent years the most important Central Banks of the world started debating on its financial impact as well.
So, we could ask, is climate change really putting the financial world at risk?
The increasing interest in sustainability for the climate change
Our society is fond of making the world more sustainable for some time. Just think that the Paris Agreement, the international treaty on climate change, was stipulated in 2015. In general, one of the main goals of Central Banks is the generation of positive externalities in their financial hub. This is one of the reasons why sustainablereserve management may even become a systematic part of large institutions.
But what are the risks that companies will face due to Climate Change?
There are two perspectives that we need take into consideration regarding sustainability:
Risk: Central Banks may find difficulty in achieving their objectives.
Impact: Central Banks need to accurately design a path towards a sustainable economy.
In terms of risks, we can divide the concerning risk into two different branches:
Transition risk: some companies might have difficulty in transition to more sustainable balance sheets in terms of competition and incoming technologies. This causes the so-called “transition risk”.
Physical risk: floods, wildfires and other environmental disasters can harm not only people but also productivity. What concerns the labour market, can be also seen in terms of migration flows.
In general, climate change is harmful to business development and operations, the supply of food, and to people in terms of damaged properties and infrastructure.
The role played by Central Banks
The topic of climate change has seen a lot of debate lately. In particular, conservatives still think that the Central Bank should focus on inflation - not to mention global warming sceptics. They don’t want monetary policy to be politicised, and they are concerned about “mission creep”. Mission creep occurs when an organisation takes on activities that don’t revolve around the main purpose. The proposal to act actually comes from activists. An example are the ones coming from the American movement for Green QE (to tilt Central Banks to environmental disclosure in balance sheets). One of the problems of policy implementation is that it might not be sufficient. This is because the majority of risks on which CBs focus are short and medium-term. However, climate risk is a long-term concern. Central Banks’ measures need to be longer due to the existence of the “tragedy of the horizon”, a threat to financial stability. That is to say that, in the longer term, the overall economy will benefit from longer-term measures.
The Paris Agreement
The Paris Agreement was adopted in 2015 by 196 different Parties. Its ultimate goal is a social and economic transformation. It should lead to limiting global warming to 1.5 degrees Celsius with respect to pre-industrial levels. Over the years, this has led to competitive zero-carbon solutions, especially in the power and transport sectors.
Policies in the US
In terms of policy implementation, the US is still lagging behind the European Union. It’s widespread knowledge that investors should be aware of climate change’s financial risks. Indeed, within two years the United States has seen more than forty weather disasters that comprised a lot of economic costs. Thus, climate-related risks can cost up to one trillion dollars. Moreover, informational asymmetry, in general, and regarding climate-related risk, in the specific, is a wide problem. For example, a market would need more information to be regarded as efficient. Indeed, the investment community has asked the SEC to require disclosure of information about the financial risks that companies incur because of climate change. The proposal focuses on physical risk and what companies would do in case of extreme weather conditions. Due to their impact on financial disclosures and business proposals it’s important to predict such cases. Also, the act by SEC ought to include the company’s specific management processes, greenhouse gas emissions, and climate-related targets. Specifically, the SEC requires public companies to provide an in-detail report of risks related to global warming, their emissions, and their net-zero transition plans.
The ECB action plan
The ECB has been one step ahead of the game regarding global warming. Indeed, the Eurosystem has two different types of targets:
Direct effects: reduction of own risk and how to conduct monetary policy.
Indirect effects: encourage greener behaviour for companies and financial institutions through disclosure and collateral policy.
All ECB policies are on the way now, in October 2022. These policies would include:
A structured climate action plan including consideration of climate change in corporate bond purchases, risk measurement and collateral framework.
Reduce financial risk related to climate change on balance sheets, and support the economic green transition.
Corporations will be given a score based on their degree of decarbonisation. Also, corporate bond holdings will favour the companies with better scores.
Reviewing the complianceof measurements with the Paris Agreement.
Enhancement of risk management practice and adjust corporate bond holding in the monetary policy. This is to enhance decarbonisation in corporations.
Entities with a higher carbon footprint will have a limit on the share of assets that they can pledge as collateral for borrowing from the Eurosystem. What’s more, the grade coming from decarbonisation may become stricter with the improvement of the transition in time. In general, companies will have to comply with the CSRD (Corporate Sustainability Reporting Directive). This will be essential when the directive is complete, to use assets as collateral in credit operations.
Rating agencies have to be more transparent about climate risk incorporation. In addition, they will need to keep an eye on climate risk disclosure requirements.
Moreover, the carbon footprints of non-financial corporations can be calculated through climate indicators. This methodology avoids threshold effects which would exclude certain securities. Regarding the needs of the public sector, we need to mobilise funds for large-scale investments to reach the goals imposed by the Paris Agreement as well.