Climate Change: Towards Action

31 March 2021 Blog

Governor Gabriel Makhlouf: All policymakers – including central banks – need to consider how climate change affects their mandates.

When I was a student, one of the papers I took was on environmental economics. Among other things, we learned about research on the impact of CO2 emissions, as well as how to use economic tools to manage pollution. Fast-forward to 2006 and Nick Stern's review of the economics of climate change concluded (persuasively as far as I was concerned) that "the benefits of strong and early actions [to avoid the worst impacts of climate change] far outweigh the economic costs of not acting". And nearly a decade later, in Paris in 2015, the nations of the world agreed on a way to manage the greatest collective action challenge mankind has ever known.

The Paris Agreement aims to limit global warming to well below 2oC, preferably 1.5oC, compared to pre-industrial levels. The environmental impacts of climate change – higher temperatures, more hurricanes, droughts and floods, for example – have become more common. If we don't achieve the Paris target, the planet of the future will look very different to the planet of today, and the human impact will be profound. The Intergovernmental Panel on Climate Change, for example, predicted that global warming of 2oC would lead to much greater biodiversity loss and changes in ecosystems, several hundred million more people in poverty, and increased intensity and frequency of adverse weather events, relative to the Paris target.

Unfortunately, last month the initial progress report from the UN Framework Convention on Climate Change showed that countries were some distance from their emissions reduction targets, with the combined efforts achieving a less than 1 per cent reduction in emissions relative to 2010 levels (described as "a red alert for our planet") and far from the required 45 per cent reduction to limit global warming to 1.5oC.

Climate change is already having profound effects on the world's societies and economies but we can alter its future path if we start taking action now.

Everyone in the community has a part to play but it is clear that Governments will need to take the lead in transitioning societies to lower-carbon paths. In fact, all policymakers – including central banks – need to consider how climate change affects their mandates and how best to respond to the climate challenge in the context of those mandates.

Climate change risk and central bank mandates

Climate change exposes economies to two main risks, physical and transition. Physical risks include extreme weather events and longer-term structural shifts in our environment such as rising sea levels or growing weather variability. Transition risks result from the shift to a lower-carbon world, and include changes in government policy and investor/consumer sentiment. The manifestation of these risks will have broad impacts, affecting macroeconomic and financial outcomes and altering the underlying structure of economies.

Imagine the impact of hurricanes, for example. Aside from human costs, they could also lead to a significant destruction of physical assets which could affect supply chains, productivity and the financial position of asset holders, which, in turn, could affect economic growth and impair the balance sheets of businesses, households and countries. Or imagine how an abrupt change in government policy or a deterioration in sentiment towards carbon-intensive products and activities could play out. It would alter demand for these products and activities, and, in extreme cases, could lead to 'stranded assets'. Global estimates of potential future losses from 'stranded assets' are sizeable; in the energy sector alone, they are estimated in the trillions of US dollars.

The broad-ranging impacts of climate change place it firmly in the bailiwick of central banks. Climate change has the potential to impair price stability, for example by increasing macroeconomic volatility, affecting potential growth and the natural real interest rate, or by impairing monetary policy transmission due to stranded assets. At the ECB, climate change is an important component of our ongoing monetary policy Strategy Review. Climate change also poses significant risk to the stability of the financial system and firms within it. So central banks must position themselves to understand these risks and the policy options to tackle them.

The Central Bank of Ireland

As a result of our broad mandate, the Central Bank of Ireland is well-placed to consider the implications of climate change for the Irish financial system as a whole. In addition to our central banking functions, we are the national macroprudential and resolution authority, as well as the prudential and conduct regulator for banks, insurance companies, investment firms and funds. We also regulate the operation of financial markets and the issuance of securities. In brief, our job is to safeguard monetary and financial stability and ensure that the financial system operates in the best interests of consumers and the wider economy.

So what are we doing to tackle the challenges posed by climate change?

First, we're embedding climate change considerations into our supervisory assessments, ensuring regulated firms are aware of their exposures and that they are incorporating climate-related risks into prudent risk management and investment practices. This is about ensuring the true environmental and indeed societal costs of climate change are factored-in appropriately from everything like the design of insurance policies, to the granting of credit, for example.

Second, we're broadening our understanding of the nature and magnitude of financial risks stemming from environmental change and how interlinkages across the economic and financial system might amplify these risks (to ensure that the financial system manages those risks appropriately), from weather events, to energy production and consumption, to household and corporate retrofitting, production processes, transportation, agriculture, to name but a few.

Third, we're working with our domestic and international partners to ensure that green and sustainable financial products are defined appropriately and identifiable to investors. These products allow investors to fund companies and activities that are sustainable. However, without the appropriate definition, products could be mis-sold, and confidence in the implementation of the sustainability agenda could be undermined. We are requiring that financial firms meet their new obligations under sustainable finance regulations.

Fourth, we recently established a Climate Change Unit to bring additional focus on all of these areas of work across the Central Bank. The Unit will help to ensure a holistic approach to our programme of actions, and will shape and steer the agenda to meet the growing challenges to our mandate from climate change.

Our goal is to ensure that climate change is a strategic priority for the financial system, and that the financial system is resilient to the risks posed by climate change and capable of supporting the transition to a lower-carbon world. We're not working on these matters alone. We are part of the Network for Greening the Financial System, a group of central banks and supervisors that exchange experiences and share best practices to contribute to the development of climate risk management in the financial sector. We are also active in a number of supervisory fora that are considering the impact of climate change on different parts of the financial sector, whether that is banks, insurance companies or investment funds, and we participate in the design of regulatory rules and supervisory frameworks at European and global levels.

And more...

Beyond our core mandate, we're also committed to playing a leadership role in embedding sustainability in our own operations. In 2018 we signed a 'Low Carbon Pledge' and committed to reducing our Scope 1 and 2 greenhouse gas emission intensity by 50 per cent by 2030, with the aim of becoming a net zero carbon emissions organisation by 2050 (organised by Business in the Community Ireland, the Low Carbon Pledge is a commitment for Irish business to invest time and resources into creating a more sustainable operation by being more energy efficient and reducing carbon usage.)

Our investment activities are also increasingly informed by climate and sustainability related considerations. In particular, compliance with the UN-supported Principles for Responsible Investment (PRI) was a condition in allocating the mandate for our equity portfolio, and we aim to increase the green bonds in our investment portfolio further this year. Moreover, last month the Eurosystem agreed to a common stance for sustainable investments in non-monetary policy portfolios. This will prepare the ground for the measurement of greenhouse gas emissions and other sustainable and responsible investment-related metrics of these portfolios. The Eurosystem aims to start making climate-related disclosures for these types of portfolios within the next two years. And, as part of the Eurosystem, the Central Bank is fully aligned with this timeline and approach.

Conclusion

The challenge of tackling climate change requires action on the part of the whole community, businesses, households, and policymakers. I anticipate a lot of international activity this year in the run-up to COP26.

The Central Bank will play its part and lead by example in its own actions, as well as deliver on its mandate to ensure that the financial system is resilient to climate-related risks and ready to support the transition to a more sustainable world.

The case for action has been made. We don't need to re-establish it, and we shouldn't let the next generation re-discover it. We just need to implement the actions that we know are needed. There's a lot to do and we're getting on with it.

Gabriel Makhlouf


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