Climate Change, the Financial System and the role of Central Bank - Vasileios Madouros, Director of Financial Stability

28 February 2020 Speech

Vasileios Madouros

Good morning.1

It is a real pleasure to have the opportunity to speak here today at the Irish Fiscal Advisory Council’s annual conference.

When I think about climate change, one book in particular often springs to mind.

It is not about environmental economics.  Or about carbon taxes.  Or about climate science.

It’s called The Diversity Bonus.2

The author – Scott Page, a social scientist and economist – makes a very compelling case for the benefits of diversity of thought, in the face of particularly complex problems.

Why is this relevant today?

Because there probably isn’t a problem facing our society that is more complex than climate change.

Climate change is already having – and is expected to continue to have – a profound effect on our planet, societies and economies.3

The scientific evidence is clear that action is needed, at a global level, to tackle climate change.4

And the transition to a low-carbon economy will require adjustments by all of us: consumers, businesses and policymakers.

Faced with a challenge as complex as climate change, a multi-disciplinary approach is not just beneficial; it is necessary.

So, in that context, today I’d like to set out what the Central Bank is doing in the area of climate change – and why.

I’ll cover three areas.

  • First, how the financial system can – and has to – play a key role in the transition to a low-carbon economy.
  • Second, how – for this to happen – the financial system itself needs to be resilient to climate-related risks.
  • Third, how central banks – including the Central Bank of Ireland – are working together to build a climate-resilient financial system.

In summary, climate change is a potential source of risk to financial stability.

So ensuring that the financial system is resilient to climate-related risks falls squarely within the Central Bank’s mandate: to serve the public interest, by safeguarding monetary and financial stability and ensuring that the financial system operates in the best interests of consumers and the wider economy.

The financial system can – and has to – play a key role in the transition to a low-carbon economy

Transitioning to a low-carbon economy will require significant investment to reduce our society’s dependence on carbon.

Indeed, given the long lifespan for some key forms of investments, especially in infrastructure, choices made today will heavily influence climate outcomes far into the future.

This investment will cover a range of activities:

  • Developing new, disruptive innovations, including some that we may not already have thought about, such as different ways of capturing and storing carbon;
  • Expanding the use of technologies that help reduce our dependence on carbon, including those that rely on cleaner sources of energy;
  • Adapting existing infrastructures, such as retrofitting homes and offices to make them more energy efficient.

While estimates of the size of this investment are highly uncertain, they are significant.

At a global level, the IPCC estimates that additional, annual, energy-related investment of around US$830bn is needed – from now until 2050 – to limit warming to 1.5oC.5

This investment will need to be financed.  And that is where the financial system can – and has to – play a pivotal role.

The basic function of the financial system is to channel savings into investment.

Indeed, finance has been at the heart of previous episodes of disruptive transformation in history from the Industrial Revolution to the Digital Revolution.

Finance both enabled those transformations but also itself adapted in response.6

So what are the key conditions needed to facilitate this channeling of savings into sustainable investment?

Well, at its most basic level, investors need to be able to understand the carbon footprint of their investments.  There’s two dimensions to that.

First, definitions: put simply, there needs to be a common understanding of what is ‘green’.

This is an area where the case for action by the public sector is clearly justified.

We cannot expect every single business, financial intermediary or investor to become experts in the science that is required to assess the contribution of a particular activity to climate change.

Indeed, in the absence of a consistent framework of definitions, financial intermediaries would likely fill that gap by making their own decisions around what sustainable economic activities are.

This is not just costly, but it can also result in inconsistent approaches, making it harder for investors to understand different financial products.

It can also give rise to ‘green washing’ – effectively the risk of misinforming investors around the green-compliant nature of different types of investments.7

The EU has taken the lead here, working on a unified classification system – or taxonomy – that will provide clarity on which activities can be considered 'sustainable'.

The taxonomy provides guidance on activities qualifying as contributing to climate change mitigation or adaptation, based on specific criteria, thresholds and metrics.

This is an essential step in supporting the flow of capital into sustainable activities in need of financing.  And it guards against the risk of ‘green-washing’.

Second, disclosure: put simply, investors need to be able to genuinely understand and assess the climate-related aspects of their investments.

Again, this is a key dimension of the EU’s sustainable finance action plan.

For example, under new legislation – the Sustainability Disclosures Regulation – when a financial product is sold as promoting environmental characteristics, the financial provider will be required to disclose information on the degree of compliance with the taxonomy.

For that to happen, in turn, financial intermediaries themselves need to be able understand the climate-related activities of different businesses.

That is why, In 2015, the Financial Stability Board established a Task Force to develop a set of recommendations around voluntary, consistent disclosures by companies on their climate-related financial risks.

Since the recommendations were published in 2016, disclosures have improved, with four fifths of the top 1100 global companies now disclosing climate-related financial risks in line with some of the TCFD recommendations.  But more progress is needed.8

As these conditions develop, the financial sector – like the rest of the economy – will need to evolve and innovate to finance the transition to a low-carbon economy.

We are already seeing some of this innovation.

The growth in green finance is just one dimension of that. Since the first green bond issued by the World Bank in 2008, the green bond market has continued to gather pace.

In 2019, issuance stood at around $260bn, almost five times higher than in 2015.

Still, as a share of the total stock of global bonds outstanding, green bonds are still in the low single digits.

To enable the transition to a low-carbon economy, green finance will need to be bigger than that – it will need to move from niche to mainstream.

In Ireland, the financial system has a key role to play to enable domestic households and business to adjust.  From retrofitting homes and offices, to increasing reliance on green forms of energy.

But – given the size and nature of our financial sector – Ireland can have an outsized impact on global outcomes.

Ireland is host to a large, internationally-focused financial sector.  Total assets of the financial system are more than €5tn.  It is host to the second largest investment fund sector in the euro area.

How these financial companies invest will matter for the global transition to a low-carbon economy.

Which is why, as part of the European System of Financial Supervision, the Central Bank has been an active contributor to the ongoing work on sustainable finance. 

And, over time, we will play an important role in supervising these new sustainable finance rules.

Doing so, will require a financial system that is itself resilient to climate-related risks

In order for the financial system to contribute to the transition to a low carbon economy, there is another key precondition.

The financial system itself needs to be resilient to the risks posed by climate change.

And this is no light task.

From a financial stability perspective – climate-related risks are unusual for a number of reasons.9

First, the effects are broad-based in nature. They affect all agents in an economy, across all sectors and across all geographies.

Second, there is a high degree of certainty that these risks will crystallise at some point in the future. But, at the same time, the precise horizon, nature and scale of these risks is highly uncertain.

Third, the horizon over which financial companies need to plan to manage these climate-related risks is probably longer than their typical planning cycle.

Precisely because climate change is unusual as a source of risk to the financial system, a lot of the work to date has focused on strengthening our understanding of the channels through which climate change can affect the financial sector.

Broadly, there are two categories of risks. Physical and transition risks.

Physical risks

Physical risks include both extreme events, like heatwaves, landslides, floods or storms as well as longer-term structural shifts in our environment such, as rising sea levels, growing weather variability, or changes in precipitation.

How do these manifestations of climate change affect the financial system?

The most direct link to the financial sector is through the insurance sector – which covers the losses borne by households and businesses when physical risks crystalize.

Weather-related insured losses – adjusted for inflation – have increased be several multiples since the 1980s.10

If insured losses resulting from such events are sufficiently large, they could lead to distress of insurance companies, with potential spillovers to other parts of the financial system.

Another potential manifestation of climate-related physical risks is the possibility of a collective withdrawal of insurers from covering some types of risks that they consider uninsurable.

That raises risks on its own.

If households and businesses cannot insure themselves against some of physical risks, or can only do so at a high cost, this would reduce their own resilience to climate-related shocks.

Consider, for example, the risk of flooding – the impact of which is very fresh in all of our minds these days.

Flooding can affect people’s homes and businesses, with devastating impacts on communities.

In addition to the distress associated with damage and loss, there are also financial costs.

If households are underinsured to flood risk, flood events can cause losses for homeowners, reducing their ability to repay loans, at the same time as damaging the value of the property.  In turn, this will affect the quality of the loan portfolios of banks.

From the perspective of financial institutions, assessing and managing these physical risks can be challenging in the face of structural changes stemming from climate change.

You cannot rely on history as a guide in pricing risk, when what used to be a 1-in-100 event in the 1960s is now a 1-50 year event, and could be even more frequent in the future.11

It is precisely in these circumstances where the potential for risk mispricing arises.

The Irish financial system is exposed to these physical risks.

Our insurance sector is very international, with exposures to catastrophic weather events across the globe, from South East Asia to the South East of the United States.

Irish banks are heavily exposed to property, with around two thirds of their loan exposures secured on property.

So it is important that these risks are assessed, managed and priced appropriately, in a forward-looking way and taking into account the latest insights from climate science.

Transition risks

The second channel through which climate change can lead to financial losses is through so-called ‘transition risks’.

This refers to the impact of the adjustment towards a low-carbon economy.

The path of that transition matters from a financial stability perspective.

A delayed and abrupt transition could result in significant changes in the valuation of some assets, with adverse implications for the balance sheets of financial institutions and losses for investors.

Even if investors merely expected an abrupt transition, this could lead to sharp adjustments in asset prices – what some have called a ‘climate Minsky moment’.12

Take the example of energy firms with investments in oil and gas fields.

An abrupt adjustment to a low-carbon economy would sharply reduce the expected future revenues from those investments.

The global estimates of potential future losses from the energy sector alone stemming from these so-called ‘stranded assets’ in a delayed and abrupt transition are in the trillions of dollars.13

And the transition risks are broader than just the energy sector.

Assume, for example, the transition away from petrol and diesel cars towards electric cars.

According to the CSO, the stock of private cards in Ireland was 2.1 million at the end 2018. There share of these that are electric or hybrid is the low single digits.

The recent government have stated in their Government Action Plan that they want to accelerate the take up of electric vehicles, so that the economy achieves a target of 950,000 of those vehicles on the road by 2030.

If that transition were to be delayed, and subsequently abrupt, the second-hand value of petrol and diesel cars could fall substantially.

But some of these cars are used as collateral in financing.14 So losses could emerge to the financial system.

Similarly, take the case of energy efficiency of homes. At the moment, around 88% of the housing stock has a BER rating at C or below.

Assume that there was a sudden shift towards higher minimum standards for energy efficiency for homes.

The value of homes with very low energy ratings could fall, as they would require a significant additional investment to retrofit them. Losses could emerge for the financial system.

These channels can then interact with other financial vulnerabilities. For example, carbon-intensive companies account for around a third of the global leveraged loan market.15

So some of the companies that are vulnerable to abrupt transition risks are also vulnerable due to high levels of debt.

Central banks’ role in building a climate-resilient financial system

Managing climate change-related financial risks involves a paradox.

Too slow a transition and risks will emerge from the physical manifestation of climate change.

Too abrupt a transition and risks could emerge due to the rapid adjustment of asset valuations.

The solution to that is to ensure that risks are identified early on and managed in an orderly and effective manner, to avoid a scenario where the financial sector has done “too little, too late”.

With that in mind, central banks globally – including the Central Bank of Ireland – are shifting their own focus.

We will increasingly be embedding climate risk issues into our financial stability assessments and supervision.

There are several ingredients that are needed to make progress in this area.

First, better understanding the transmission channels of climate-related risks, as relevant to Ireland.

This means identifying which types of physical and transition risks matter most for Ireland and the financial system here.

It covers questions like the interaction between flood risk (now and in the future) and the location of the mortgage stock; the impact of weather-related events on the agricultural sector; or the impact of severe weather events globally given global exposures of the Irish insurance sector.

To get this right, we have to work with external climate experts to provide advice on the latest insights from climate science, for us to be able to translate these in terms of the potential impact on the macro-economy and financial sector.

Second, identifying data gaps on exposures and seeking to fill these.

This will involve looking at exposures of financial institutions through a different lense.

For example, it might cover the distribution of the mortgage stock by BER rating; or the size of secured loan exposures with diesel/petrol vehicles as collateral.

For us to be able to assess exposures to climate-related risks, regulated firms themselves will need to have access to this information.

Third, gradually, building our understanding of the potential impact of different climate-related scenarios on the financial system.

A key feature of climate change as a source of financial risk is that we cannot look to history as a useful guide to the future.

In that context, scenario analysis is likely to be a more fruitful avenue for assessing the resilience of the financial system.

But even building such scenarios entails challenges.

Different pathways to a low-carbon economy imply a different combination of potential physical and transition risks.

The toolkit for mapping from a crystallisation of either physical or transition risks to potential macrofinancial outcomes is still developing globally.

And the horizon for such scenarios may need to be much longer than the typical scenario planning horizon.

Advancements in this area have began, but we are at the start of this journey at a global level.

Which brings me to my final point, enhancing climate risk management by regulated firms themselves.

From a sectoral perspective, we know that the insurance sector has somewhat of a head start.  Given their business models, some insurers have more experience in managing risks stemming from climate-related events.

Across the financial system, though, there is still much further to go to ensure that regulated firms manage climate-related risks appropriately – in a way that becomes integrated into their practices and part of their business as usual risk assessment.

From the perspective of the Central Bank, we know this is a challenge.  We will not develop the expertise in this area overnight. This will be a multi-annual work programme.

Which is why we are not working alone on this. The Central Bank last year joined the Network for Greening the Financial System.

This is 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.

The Central Bank is 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.


Let me finish off where I started.

The collective challenge ahead of us in tackling climate change is immense.

Given the complexity of the problem we face, a multi-disciplinary approach is necessary.

Central banks will not drive the transition to a low-carbon economy. This is the role of elected governments.

But understanding the impact of climate change and the transition to a low-carbon economy is crucial to delivering our own mandate.

This will require a transition in our own thinking – as well as that of regulated firms. So our focus in this area is growing.

And this is how we can contribute to the broader agenda.

A climate-resilient financial system is a necessary condition to enable the transition to a low-carbon economy.

We cannot have a situation where concerns around the resilience of the financial system act as an obstacle to that transition.

Thank you for your attention.

1I am very grateful to Yvonne McCarthy, Kieran Sheehan and Philip Brennan for their contributions and assistance in preparing these remarks.

2The Diversity Bonus, Princeton University Press, 2017.

3IPCC, Climate change 2014: Synthesis report summary for policymakers, 2018


5IPCC, Summary for Policymakers, 2018. The OECD also estimates that around US$6.3tn of annual investment in energy, transport, water and telecommunications infrastructure will be needed to sustain growth up to 2030.  An additional US$600bn would be required to be compatible with a 2°C scenario. OECD, Investing in Climate, Investing in Growth, 2017.

6Perez, Technological Revolutions and Financial Capital, Edward Elgar Publishing 2002; Cameron, Banking in the Early Stages of Industrialisation, Princeton University Press, 1967; Brunt and Cannon, How Does Finance Generate Growth? Evidence from the First Industrial Revolution, 2009; Matthias, Capital, Credit and Enterprise in the Industrial Revolution’ in The Transformation of England, 1979.

7Rowland, The Role of Financial Conduct Regulation and 2020 Priorities.

8Carney, TCFD: Strengthening the Foundations of Sustainable Finance, 2019; and TCFD, 2019 Status Report.

9NGFS, A Call for Action: Climate Change as a Source of Financial Risk, 2010.

10Sigma Explorer. The increase in these losses is generally considered to be driven primarily by exposure (ie increasing value of property in high‑risk areas).

11Blöschl, Hall and Živković, Changing climate both increases and decreases European river floods, Nature 2019, Vol 573.

12Carney, A Transition in Thinking and Action, 2018.

13NGFS, Macroeconomic and Financial Stability Implications of Climate Change, 2019.

14Central Bank of Ireland, Household Credit Market Report, 2019.

15PRA, The Impact of Climate Change on the UK Insurance Sector, 2015.