Towards a climate-resilient financial system - Vasileios Madouros, Director for Financial Stability

05 November 2019 Speech

Vasileios Madouros

Good morning. It is a real pleasure to have the opportunity to speak here today as part of Climate Finance Week.1

I wanted to start with a disclaimer.

I am not an expert in the science of climate change.

But that is no excuse for me – as a central banker – not to take climate change seriously.

Only a few years ago, it would have been a rare occurrence to hear central banks speak about climate change. But climate change has been rising rapidly on our agenda of priorities.2

The reason for that is simple. We have become acutely aware that understanding the impacts of climate change and the transition to a low-carbon economy is crucial to delivering our mandates.

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.

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

I’ll make two simple points.

  • First, the financial system can – and has to – play a key role in the transition to a low-carbon economy.
  • Second, for this to happen, the financial system itself needs to be resilient to climate-related risks.

This 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.

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 or investor to become experts in the science that is required to assess the contribution of a particular activity to climate change.

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 will provide clear 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.

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

This is another area where lack of co-ordination amongst individual companies may lead to suboptimal outcomes for society.

For disclosure to be useful, it needs to be consistent, both across firms and over time.

This 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.7

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 2018, issuance stood at around $170bn, almost four times higher than in 2015. Last year also saw inaugural sovereign green bond issues from five countries, including Ireland.

Still, green bonds account for around 1% of the total stock of global bonds outstanding.

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 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.

My colleague Gerry Cross is covering some of the regulatory issues with a particular focus on investment funds later today.

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.8

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 very 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.

The effects of climate change are already being felt.

Weather-related insured losses have increased from an average of around US$10 billion per annum in the 1980s to an average of around US$58 billion per annum so far this decade.9

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 increased frequency of floods.

If households are underinsured to flood risk, flood events can cause significant 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.10

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.

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’.11

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.12

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

Assume, for example, that there was a sudden shift away from petrol and diesel cars towards electric cars.

The second-hand value of petrol and diesel cars could fall substantially. But some of these cars are used as collateral in financing.13 So losses could emerge to the financial system.

Similarly, 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.14

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

The Central Bank’s role

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, the Central Bank is shifting its own focus.

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

We are not working alone on this. The Central Bank this 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.


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

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

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

A climate-resilient financial system is a necessary condition to enable finance to play its role in the transition to a low-carbon economy.

Thank you for your attention.

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

[2] Sharon Donnery (2019) Risks and Opportunities from Climate Change, Philip R Lane (2019) Climate Change and the Irish Financial System.

[3] IPCC (2018) Climate change 2014: Synthesis report summary for policymakers.

[4] Ibid.

[5] IPCC (2018) Summary for Policymakers in Global Warming of 1.5o. 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. See OECD (2017) Investing in Climate, Investing in Growth.

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

[7] Mark Carney (2019) TCFD: Strengthening the Foundations of Sustainable Finance and TCFD (2019) 2019 Status Report.

[8] NGFS (2010) A Call for Action: Climate Change as a Source of Financial Risk.


[10] Blöschl, Hall and Živković (2019) Changing climate both increases and decreases European river floods, Nature 2019, Vol 573.

[11] Mark Carney (2018), A Transition in Thinking and Action.

[12] NGFS (2019) Macroeconomic and Financial Stability Implications of Climate Change.

[13] Central Bank of Ireland (2019) Household Credit Market Report.

[14] PRA (2015) The Impact of Climate Change on the UK Insurance Sector.