Kapitel 5

chapter 5: financial and monetary sectors

(impacts on the financial sector)

• credit risk

• market risk

• liquidity risk

Network for Greening the Financial System

• The NGFS was formed in December 2017 by central banks and supervisors to advance environmental and climate risk management in the financial sector and support the transition to a sustainable economy.

A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, severe impact, and the widespread insistence they were obvious in hindsight (=understanding of a situation or event only after it has happened or developed - "with hindsight, I should never have gone“)

the “paradox is that success is failure”: extremely rapid and ambitious measures may be the most

desirable from the point of view of climate mitigation, but not necessarily from the perspective of financial stability over a short-term horizon.

Key point: are losses covered by insurance or not?

Events resulted in the insolvency of several insurance companies.) => failure and distress of insurers could affect financial stability if they were to lead to disruptions to critical insurance services and systemically important financial markets => large-scale sales of assets => reduce asset prices and affect the balance sheets of other financial institutions, such as banks.

Insurance companies underestimate the risks ex ante (rely heavily on historical data ) => as a result they hold insufficient capital.

This has led to a withdrawal of insurers from covering risks that they consider uninsurable or they raise premiums for covering similar risks.

BUT reduced insurance coverage could in turn reduce the collateral values in affected areas, which could tighten the borrowing constraints of households and corporates.

Severe weather-related catastrophe could affect the banking sector and the real economy in the medium-term.

The impact of uninsured losses can have significant consequences for the insurance industry, financial system, and the economy as a whole. Insurance companies may withdraw from covering weather-related risks, leading to underinsurance or increased premiums. This can reduce collateral values, tighten borrowing constraints, and magnify the economic impact of disasters. Weak balance sheets of households and corporates, persistent financing needs, and reduced lending by banks can further worsen the post-disaster downturn. Additionally, there can be international spillovers, increased default risk, and disruptions in banking services. Central banks may need to intervene to stabilize the financial system in such situations.

Central Banks may have to intervene as climate rescuers of last resort:

For example, a new financial crisis caused by green swan events severely affecting the financial health of the banking and insurance sectors could force central banks to intervene and buy a large set of carbon-intensive assets and/or assets stricken by physical impacts.

While banks in financial distress in an ordinary crisis can be resolved, this will be far more difficult in the case of economies that are no longer viable because of climate change. Intervening as climate rescuers of last resort could therefore affect central bank’s credibility and crudely expose the limited substitutability between financial and natural capital.

It may be that the CBs are obliged to be the “only game in town” and to substitute for other if not all government interventions, this time to fight climate change.

For instance, it has been suggested that central banks could engage in “green quantitative easing” in order to solve the complex socioeconomic problems related to a low-carbon transition.

Relying too much on central banks would be misguided:

1. the instruments that central banks and supervisors have at their disposal cannot substitute for

the many areas of interventions (fiscal, regulatory and standard-setting authorities) that are needed to transition to a global low-carbon economy.

2. It risks overburdening central banks’ existing mandates. Mandates can evolve, but these changes and institutional arrangements are very complex issues and require building reputation and credibility.

Microeconomic transmission:

• climate change affect banks’ individual counterparties, potentially resulting in climate-related

financial risk to banks and to the financial system;

• it includes the direct effects on banks themselves, arising from impacts on their operations and their

ability to fund themselves.

Macroeconomic transmission:

• are the mechanisms by which climate risk drivers affect macroeconomic factors (for example,

labour productivity and economic growth) and how these, in turn, may have an indirect impact on banks through an effect on the economy in which banks operate.

Physical and transition risk impact a bank’s credit risk when:

• a borrower is not able to repay and/or to service debt (the income effect) or

• the value of a collateral is reduced and the bank’s cannot fully recover the value of a loan (the

wealth effect).

Households: severe weather events impact home prices. If mortgage customers default and values of collateral are reduced => banks are in trouble. Evidence:

• prices of houses in floodplains decrease following a severe weather event

• sea level rise and repeated flooding could damage property in coastal areas and lead to large

devaluations of residential real estate

• prices for flooded neighbourhoods dropped nearly 20% in New York City after Hurricane Sandy, and

three years later, homes in those neighbourhoods were still valued 10% lower than those in unflooded neighbourhoods

Banks with residential property as mortgage collateral in impacted regions could see their credit risk increase.

Corporates: acute physical risks reduce corporates sales and profitability and potentially increase credit risk to lenders. Examples:

Natural disasters can result in decreases in corporate sales. US corporates experienced an average drop of 2 to 3 percentage points in sales growth following a major natural disaster that affects their suppliers, ultimately causing a 1% drop in corporates’ equity value. Impact of disasters through GVCs.

Global supply chains impact banks’ counterparties. Although difficult to quantify (complexity of global economic system, data gaps etc), the effects may be significant as developed countries are increasingly reliant on long supply chains and on supplies and services provided by countries vulnerable to climate risk.

Higher temperatures and changes in precipitation decline in yields of corn, soybeans and cotton by the end of the 21st century and the impact on farmland value is predominantly negative under a range of global warming scenarios.

Sovereigns and subnational institutions: Tax and spending channels

• Lower tax revenues from corporates, reduced household income and an overall reduction in output.

• Higher government spending is likely to take place in an effort to address the negative economic

impacts and cover adaptation costs.

Sovereigns could be confronted with higher borrowing costs or limited access to debt markets => heightened credit risk within banks’ sovereign and municipal exposures.

For example, some Caribbean governments’ restricted access to financial markets, with governments facing worse borrowing conditions when extreme weather becomes more frequent and more intense.

Transitions to lower-carbon economies

• may make extracting a large proportion of fossil fuel reserves uneconomical

• create so-called “stranded assets” that are no longer able to earn an economic return

we should stop using fossil fuels, 80% of it should stick in the ground

Outcome:

• Corporates extracting fossil fuels would become vulnerable; reduced values for those reserves on their books

• Increase their propensity to default

• if the fossil fuel reserve assets are used as collateral for loans, their devaluation could result in a significant reduction in the credit risk mitigation provided by that collateral

Sentiment: shifts of consumer and market sentiment to less carbon-intensive products or investments because they become more aware of climate change.

For example,

• in the automobile industry, consumers may increasingly prefer cars with lower GHG emissions.

• As a result, traditional automobile manufacturers who continue to produce high GHG emission cars see the future of their brands compromised, regardless of regulatory or technical initiatives.

Retail and wholesale clients may manage their savings or investments towards projects with a positive environmental impact.

As noted above, cost of capital and funding for some corporates may increase as equity and debt investors and rating agencies include climate-related or environmental factors in their investment and rating decisions. Rating agencies have already initiated negative rating actions in response to climate risk factors such as drought and hurricane losses.

market risk

Climate risk drivers can have a significant impact on the value of financial assets.

The main transmission channel originates from new information about future economic conditions or the value of real or financial assets.

The new information is related to any developments coming from physical and/or transition risks and may result in a downward price shocks and an increase in market volatility in traded assets.

However, where climate risk is already priced in, the potential for unexpected price movements may be reduced.

Market physical risk

Uncertainty about the timing, intensity and location of future severe weather events and other natural disasters may lead to higher volatility in financial markets however analysis of the impact of physical risks on financial markets is limited.

Studies show that:

• the risk of a consumption shock similar to one following a natural disaster explains high levels of stock

price volatility.

• stock options of firms located in the forecasted trajectory or eventual landfall region of a hurricane experience an increase in implied volatility.

There is little research on the impact of physical risk drivers on other aspects of capital.

market transition risks:

Transition-related changes in policy

• Technological advances and

• Investor sentiment

could lead to changes in borrowing costs and an abrupt repricing of financial assets.

Investors in financial markets could reward borrowers who believe will be resilient/flexible through, or may stand to gain from, the transition away from a carbon-intensive economy. At the same time, investors could increase the risk premia they demand from carbon-intensive borrowers.

However, work performed by academics and financial institutions to analyse potential risk differentials between assets that are more or less sensitive to transition risks is limited and is generally inconclusive

UNEP-FI considered a portfolio of 30,000 listed companies under a 1.5°C scenario by 2100, and estimated that the portfolio could lose 13.16% of its value as a result of the transition to a low-carbon economy (UNEP-FI (2019));

market pricinig in risks:

There is limited information on the pricing-in of climate risks from abrupt effect of climate change in the future following severe weather events or a rapid transition to a less carbon-intensive economy.

Researchers have found some evidence of municipal bonds pricing in climate change

• the effects are generally small, and specific to longer-maturity bonds.

• Painter (2020) finds that municipal bonds issued by US counties exposed to climate risk require higher initial yields compared to counties unlikely to be affected by climate change

• Goldsmith-Pinkham et al (2021) find small differences in yields on municipal bonds exposed to sea level rise, particularly on the east coast of the United States, after 2013.

Market signals show a negative impact on US oil exploration firms expanding undeveloped oil reserves, indicating lower expected returns. Pricing of climate risk in equity markets is not widely observed, although some carbon-intensive companies may reflect climate risk. However, specific studies suggest that certain residential real estate valuations already account for flood risks and sea level rise.

Climate change drivers may impact banks’ liquidity through their ability to raise funds or liquidate assets, or indirectly through customers’ demands for liquidity.

• If households and corporates affected by physical risks need liquidity to finance recovery and other cash flow needs, they may withdraw deposits

• These withdrawals could put the bank’s own liquidity under pressure and lead to crystallised liquidity risks within banks.

Findings

• Brei et al (2019): banks in their study faced deposit withdrawals following a hurricane in the Caribbean, but

• Steindl and Weinrobe (1983) find the opposite: an increase of deposits following natural disasters in the United States.

• While studies have analysed the effects of transition risks on the liquidity and funding of corporates, the subsequent effect on bank liquidity has not been studied.

• Whilst the above examples of behaviours in response to severe natural disasters may be valuable in aiding understanding of climate-related liquidity risk, they also demonstrate the need for further research in this area.

operational and reputational risks:

operational risk is defindes as:

• the risk of loss re sulting from inadequate or failed internal processes, people and systems or rom external events.

• This definition includes legal risk, but excludes strategic and reputational risk (strategic and reputational risks should be considered by banks’ operational risk management).

Physical hazards can affect banks directly as operational risks.

There is little public research on the operational risks faced by banks and arising from physical risk drivers, but there are parallels to be found in other natural disasters.

For instance, if physical hazards disrupt transportation facilities and telecommunications infrastructure, banks’ operational ability may be reduced.

Conclusion: further research would be welcome.

While the microeconomic channels have direct and indirect impacts on banks, the macroeconomic transmission channels are ‘indirect’. They relate to:

• increase in human mortality and

• Decline in labour productivity Both are drivers of reduction in output.

Carleton and Hsiang (2016): increases in temperature adversely impact mortality, morbidity, agricultural yields, labour supply, and productivity.

The cost of recovery following a natural disaster can be significant particularly for poorer countries.

Morbidity is the state of having a specific illness or condition. While morbidity can refer to an acute condition, such as a respiratory infection, it often refers to a condition that’s chronic (long-lasting). Some examples of common morbidities include: diabetes, high blood pressure,

Mortality refers to the number of deaths that have occurred due to a specific illness or condition.

Mortality is often expressed in the form of mortality rate. This is the number of deaths due to an illness divided by the total population at that time.

Increased borrowing costs could lead to:

• higher taxes,

• lower government spending and

• reduced economic activity,

• which may indirectly impact banks’ credit risk.

• Diffenbaugh and Burke (2019) posit that climate change has already driven substantial declines in economic output in hotter, poorer countries and increases in economic output in cooler, wealthier countries.

• The contrast is more apparent when looking at the 10 largest disasters between 1970 and 2018. While emerging markets incurred damages between 2.9 and 10.1% of GDP, advanced economies experienced damages equivalent to 1–3.2% of GDP (IMF (2020)).

• These reductions in GDP may impact the country-level assessment of credit risk by banks

Turning to a greener economy projected to result in the fossil fuel reserves (around 80%) becoming stranded resources, 90% of Africa’s coal reserves (Bos and Gupta (2019)).

That will have significant implications for government revenues and spending in some of the poorest countries reliant on fossil fuel revenues.

• Climate-related income effects on sovereigns could hamper their ability to service their debts, in turn impacting the value of their bonds, their credit ratings and the credit ratings of those institutions associated with the sovereign. In turn, this is expected to increase the credit risk of banks facing these counterparties.

Moreover additional effects on counterparties could have macroeconomic impacts:

• Government impose carbon emission taxes and/or

• increased prices in carbon-intensive supply chains or

• Consumers change their preferences.

Higher costs of production => profitability declines => lowers investment and equity prices. High prices => curtail household disposable income and lowering consumption.

Lower C and I, reduces GDP => reduced income for households, corporates => deterioration in their ability to service their debts, increasing the credit risk of their banks.

Climate change is relevant for central banks because their objective is to maintain price stability. Climate change impacts key variables such as GDP growth, food prices, and inflation. Central banks consider the temporary or lasting effects of climate-related shocks in their monetary policy responses. If the impact is temporary, they may adopt a "wait and see" approach. However, if the shock has lasting effects, adjustments to aggregate demand conditions may be necessary. The challenge with climate change is its long-term trajectory, which can result in stagflationary supply shocks that monetary policy alone may be unable to fully reverse. Additionally, climate change is a global problem that requires global coordination, which can be challenging for monetary policy. Central banks may face difficulties in effectively responding to inflationary climate-related shocks, and preemptive measures to hedge against fat-tail climate risks may be necessary.

The interest rate channel refers to the mechanism by which changes in the policy interest rate directly impact money-market interest rates, which in turn influence lending and deposit rates set by banks for their customers. An increase in the policy interest rate leads to higher lending and deposit rates, which affects borrowing costs for firms and households.

Under the expectations hypothesis of the term structure, an increase in short-term nominal interest rates is expected to persist and result in higher longer-term nominal interest rates. As nominal prices adjust slowly, these movements in nominal interest rates also translate into changes in real interest rates. Higher real borrowing costs for firms and households lead to reduced investment and purchasing decisions, impacting supply and demand conditions in goods and labor markets and having a downward impact on inflation.

In the context of higher risk aversion and increased uncertainty due to climate-related risks, households tend to increase precautionary savings, and firms scale back on investment. If the sensitivity of investment to interest rates decreases, a given change in the policy interest rate will have a smaller impact on output. As a result, standard monetary policy becomes less effective in stimulating economic activity.

Credit channel. The credit channel is likely to reflect some of the most significant impact of climate change on monetary policy transmission.

• First, climate-related risks can affect the credit channel through the deteriorating

creditworthiness of borrowers. (i) For example, firm and household balance sheets may be hit – directly and indirectly – by various physical risks (such as floods, fires, or storms) their asset value will decline. (ii) New environmental regulations and transition policies may also reduce the net present value of many assets

[From the standpoint of the lenders, a higher likelihood of default among households and firms will likely raise the perceived riskiness of their loans.] The net supply of loans could therefore decline at any given level of the risk exposure desired by lenders.

• Second, more frequent and disruptive extreme weather events could increase the banks’ stock of non-performing loans (NPLs), with negative consequences for their balance sheets. Moreover, in case of a damage or an abrupt and disorderly transition, credit spreads could rise for carbon intensive firms, for example, if a significant share of their assets might become stranded or liability risks materialize. This is likely to put pressure on balance sheets of banks [and other lenders as carbon intensive assets and loans are revalued.]

Third, a further source of stress could come from market funding of banks, which could dry up when faced with mounting uncertainty related to climate risks. [Example GFC no one wanted to borrow money] Of course, the market is not the only source of funding for banks. Since the great financial crisis, central banks have increasingly intervened to ease financing conditions for banks, with a view to ensuring smooth provision of credit to firms and households in the real economy. However, climate-related risks may also affect the collateral that banks need for central bank refinancing operations. Given central banks’ obligation to manage risk prudently, they may need to adapt their collateral framework to adequately reflect climate risk. [If this is done by introducing restrictions on the pool of bank assets eligible for refinancing, additional central bank measures may be required to ensure the continued provision of adequate liquidity in the banking sector.]

• Fourth, the credit channel of monetary policy transmission could also be affected by the impact of climate change on the level of interest rates and bank profitability. The current low-interest rate environment has already eroded bank profitability, possibly weakening interest rate pass-through to bank lending rates. If climate change leads to an even longer period of low interest rates, bank interest rate margins could remain compressed for longer or could be further compressed, further denting their profitability. In these conditions, banks could find it difficult to meet capital requirements and thus they could further restrict their loan supply.

Asset price and wealth channels:

Increase in the nominal interest rates

• raise the attractiveness of new debt instruments compared to equities and existing debt.

• induces smaller investment expenditures by the affected firms

• changes in asset prices can have an impact on aggregate demand via changes in the value of collateral, affecting the amount that borrowers can borrow.

• For example, as asset prices rise, household financial wealth increases, share-owning households and house owners become wealthier and may choose to increase their consumption.

  
  

Climate change on ‘Asset price’

• Extreme weather events could lead to more frequent and more severe episodes of financial market disruption

changing asset prices

• gradual warming could redistribute demand across regions and sectors of production, affecting firms’ relative return on equity creating “stranded assets”, triggering firm revaluations. In addition, physical risks will lower the value of residential property or capital assets in areas exposed to fires, floods or desertification. Such losses, in turn, will have wealth effects on household consumption and influence firm investment.

Exchange rate channel:

In open economies, if domestic nominal interest rate rises above its foreign counterpart =>

• the domestic currency will tend to appreciate towards foreign exchange rates, due to its increased attractiveness as an investment currency.

• When prices are slow to adjust, this makes domestically produced goods more expensive than foreign produced goods. Net exports fall, as do domestic output and employment, while inflation decreases.

  
  

• Climate change on ‘Exchange rate’:

Climatechangeislikelytoalterthecompositionofoutputincertaincountriesandthepatternof international trade more generally. Over time, this could erode the terms of trade in countries that are more exposed to climate risks. In particular, climate change may transform individual euro area countries’ exposure to extra-euro area trade, weakening the exchange rate channel for some euro area countries, while strengthening it for others. By thus increasing heterogeneity within the euro area, climate change could affect monetary policy transmission as well as exchange rate pass-through to overall euro area inflation.

Expectations channel:

 Expectations of future official interest rate changes affect medium and long-term interest rates.

 The CB’s can with its measures and communication, influence and guide economic agents’ expectations of future inflation and thus influence price developments by signalling the future course of monetary policy.

 Expectations of future interest rates matter because they affect important economic decisions such as investment and durable consumption and thus, indirectly, employment, production and price-setting.

Climate change on ‘Expectations’

• The growing uncertainty associated with climate change might also weaken the expectations channel of monetary policy transmission. A disorderly transition and financial market disruptions could make it more difficult for central banks to distinguish demand shocks from supply shocks. This, in turn, could pose a challenge for central bank communication and confuse private sector expectations of future monetary policy.

There is no difference between term structure and a yield curve; the yield curve is simply another name to describe the term structure of interest rates.

What Is the Term Structure of Interest Rates?

The term structure of interest rates is a graph that plots the yields of similar bonds in the Y-axis with the maturities, or time, in the X-axis.

The reason why the term structure of interest rates and a yield curve are the same is because the graph of the term structure of interest rates literally plots different yields being offered by bonds of different maturities. The term structure of interest rates can take one of three yield curve shapes: normal, inverted, or flat.

A normal yield curve means that as the maturity of the bonds increases in time, so do the yields, creating a convex shape.

An inverted yield curve means short-term yields are higher than long-term yields, and the curve slopes downward in a concave fashion. This means yields and maturities are negatively inverted.

A flat yield curve means there is little or no variation between yields and maturities, and all maturities have similar yields. This makes the yield curve parallel to the X-axis.

Generally, the term structure of interest rates is a good measure of future economic growth expectations. If there is a highly positive normal curve, it is a signal investors believe future economic growth to be strong and inflation high. If there is a highly negative inverted curve, it is a signal investors believe future economic growth to be sluggish and inflation low. A flat yield curve means investors are unsure about the future.

The natural rate of interest r* is the rate consistent with stable inflation when the economy is growing at its trend.

The natural rate is not directly observable - serves as benchmark for the stance of monetary policy. If r* low, the space for the CBs is tight if they want to provide monetary accommodation. The risks of hitting the effective lower bound (ELB) is high.

• The two most powerful channels seem to be the impact on productivity and uncertainty.

How climate change affect Productivity?

• Physical risks can damage commercial property and production equipment at a higher speed than under current climate conditions (a higher obsolescence rate)

=> This will lead to a diversion of resources away from innovation and towards reconstruction, adaptation and prevention of further damages. If substantial resources are diverted to fund adaptation policies, they cannot be invested in R&D, thus lowering productivity growth.

• Transition risks might also turn productive investments into stranded assets => physical and transition risks can lead to increasing rates of capital depreciation, thereby lowering the capital stock and productivity.

• The effect of climate-induced replacements on total factor productivity is unclear:

• After a natural disaster, the damaged machinery replaced with the latest more productive technology

=> which could give a positive productivity boost

• But if the impairments ofphysical assets multiply ,funds will be deployed for replacement and repair investments => firms have less funding for R&D, lowering their capacity to implement to new technologies.

Moreover

• Firms might have to invest to comply with new regulation; this might detract resources from other productive inputs while not increasing value added.

• Some firms might not be able to afford those new investments and be forced out of the market.

• The impact will most probably be the same for frontier firms (positive) vs. laggards (negative) in a given

sector.

• Encourage innovation with benefits to productivity growth in the long-run.

Empirical evidence is highly inconclusive, but tends to find a negative short-run impact on productivity growth while in the long-term results are mixed.

Climate change increases uncertainty by introducing higher economic tail risk and overall uncertainty. This leads to a higher risk premium, which reduces the willingness to invest and increases the propensity to save. These factors lower the natural interest rate (r*). Climate change-related uncertainty also generates a high demand for safe assets, as investors seek to mitigate risks. This increased demand for safe assets raises the premia paid for holding them, further decreasing r*. This phenomenon, known as the safe asset channel, exerts downward pressure on the natural interest rate. However, quantifying the precise impact of these financial channels on r* and how climate change risks are priced in bond yields is still limited in research.

Overall, the precise impact on r* through such financial channels is hard to quantify; research in terms of quantity and intensity on how risks associated with climate change are priced in bond yields is scarce.

Climate change could increase government debt through higher mitigation and adaptation investment or through higher expenditure to cover health and other costs of natural disasters. A higher supply of sovereign assets in the economy might then increase r*. But the quality and composition of fiscal policies in the context of climate policies also matters.

An orderly transition with an adequate carbon pricing, whereby the proceeds are mostly used for social spending to compensate the losers from carbon pricing =>

• higher supply of sovereign assets => positive sign on r*

If all the proceeds were used to support public investment and innovation, which would support TFP =>

• Short term r* could be mitigated or the sign of the impact could switch growth (and thus improve long-run fiscal sustainability).

Productivity and uncertainty seem to be the most powerful channels for the policy space.

• Overall, climate change can be expected to drive both down, at least until the transition is completed, putting further downward pressure on r*, except in the case of ‘strong’ green growth that would boost productivity. Yet this is subject to nuances and qualifications.

• An additional challenge for the ECB is that the effects of climate change on these drivers may differ across EMU countries both in terms of potency and timing. This opens up complicating scenarios for monetary policy, rendering it more difficult for the ECB to reach its price stability objective over common definitions of the policy horizon. This may call for an increased flexibility in the monetary policy strategy, both in terms of objectives and time horizon.

• Different physical risks in different regions, different probabilities, different severity;

• Increase of the av. EA temperature of 1.5 degrees can have high deviation;

• Rising sea levels will affect countries with long coast lines disproportionately; glaciers also;

• These country-specific differences are likely to evoke heterogeneous policy reactions by national policy makers.

Supply shocks and price stability

Supply shocks tend to increase prices while at the same time lowering output

For a CB supply shocks are problematic: dilemma between stabilizing inflation and economic activity. If CBs assess the shock to be short-lived, they may tolerate the temporary effects without taking any

action, to avoid undue volatility;

If they assess the shock to be more persistent (second-round effects on wages and inflation and an

unanchoring of inflation expectations), then policy action may be warranted.

Extreme weather events can be primarily thought of as supply shocks, which in the short run tend to increase prices while at the same time lowering output.

From the perspective of the central bank, supply shocks are problematic as they confront it with a dilemma between stabilizing inflation and economic activity.

If CBs assess the shock to be short-lived and unlikely to affect the medium-term inflation outlook that is relevant for monetary policy, they may “look through” such a shock. Under these conditions, the central bank may tolerate the temporary effects of the supply shock on inflation without taking any action, in order not to cause undue volatility in output and employment.

The transition towards a climate-neutral economy will affect prices and hence price stability through various channels.

Uncertainty:

• Climate change is associated with uncertainty and cannot be quantified based on known probability distributions of events.

• This troubles the monetary analysis and makes it more difficult to identify the appropriate monetary policy response.

Climate change introduces fundamental uncertainty to the economy, with complex interactions and non-linear dynamics. This makes it challenging to analyze and respond to its economic impact, posing difficulties for monetary policy.

Reacting to climate change: passive or defensive actions

• Central banks should preserve their ability to deliver on their price stability mandate against materialisation of climate risks.

• Central banks must assess, and where appropriate adopt, appropriate risk management measures to protect their balance sheets against emerging climate-related financial risks

Deepen the analysis of the effects of climate change on the economy and the financial system

Develop new analytical tools and models designed to assess the impact of climate change on the economy and financial markets: e.g. research papers on the potential consequences of climate change for the macroeconomy

Integrity of their balance sheets and prudently manage the resources entrusted to them:

Policies could be considered to reduce the weight of polluting assets in central banks’ portfolios.

Central banks could also review their monetary policy frameworks to assess how they may adapt to the above risks and shocks:

Is inflation targeting the most appropriate monetary policy regime to stabilise the economy after a natural disaster?

The second category of central bank measures to mitigate climate change includes actions aimed at raising awareness of climate risks.

• communicate and inform with the public and financial community about climate risks;

• disclose the carbon footprint of the central bank’s own balance sheet

Central bank communications raising awareness of climate-change related risks in the financial markets and among the general public.

• speeches by central bankers, discussions of the economic and financial implications of climate change in central bank bulletins and other official communications,

• promoting research and organising conferences and seminars to inform and advance the debate in the field.

The third category of measures available to central banks to tackle climate change includes action aimed at proactively mitigating climate change and promoting the transition to a low-carbon economy, including through active use of their balance sheets.

Non-monetary policy portfolios, such as staff pension funds and own funds, constitute a suitable starting point for actively greening central banks’ portfolios.

Because they are not subject to a policy mandate and contain a relatively diverse set of assets.

Announce plans to incorporate climate change considerations in their corporate bond holdings under their monetary policy portfolios.

Some central banks have started to consider ways to explicitly incorporate green considerations into existing quantitative easing (QE) programmes deployed for monetary policy purposes.

Central banks can green their implementation framework by reviewing the pricing or eligibility criteria for collateral they accept as part of lending operations.

Central banks could require that the carbon footprint of eligible collateral be disclosed and/or pursue negative screening for certain types of financial assets when used as collateral.

Article 3(3) TEU provides that the Union

“shall work for the sustainable development of Europe based on balanced economic growth and price stability, a highly competitive social market economy, aiming at full employment and social progress, and a high level of protection and improvement of the quality of the environment”

Loss given default (LGD) is the amount of money a bank or other financial institution loses when a borrower defaults on a loan, depicted as a percentage of total exposure at the time of default.

climate change: uncertainty, risk, potentially deep transformations in our lifestyles, prioritising long- term ethical choices over short-term economic considerations, and international coordination for the common good.

Covered by insurance: If losses are large => distress or failure of insurance companies (e.g, Hurricane Andrew in 1992 resulted in the insolvency of several insurance companies.) => failure and distress of insurers could affect financial stability if they were to lead to disruptions to critical insurance services and systemically important financial markets => large-scale sales of assets => reduce asset prices and affect the balance sheets of other financial institutions, such as banks.

If they do not withdraw they increase the insurance price which can lead to underinsurance, which in turn could reduce collateral values => reduce lending in the presence of borrowing constraints.

Underinsurance, credit constraints, delays in reconstruction can magnify the economic impact of disaster. Reconstruction contributes positively to GDP.

• a borrower is not able to repay and/or to service debt (the income effect)

the value of a collateral is reduced and the bank’s cannot fully recover the value of a loan (the wealth effect)

Households: severe weather events impact home prices. If mortgage customers default and values of collateral are reduced => banks are in trouble

The main transmission channel originates from new information about future economic conditions or the value of real or financial assets.

The new information is related to any developments coming from physical and/or transition risks and may result in a downward price shocks and an increase in market volatility in traded assets.

However, where climate risk is already priced in, the potential for unexpected price movements may be reduced.

Higher costs of production => profitability declines => lowers investment and equity prices. High prices => curtail household disposable income and lowering consumption.

Lower Consumption and Investment, reduces GDP => reduced income for households, corporates => deterioration in their ability to service their debts, increasing the credit risk of their banks.

Central banks conduct monetary policy by balancing and influencing the development of inflation

and the real economy.

• Climate change affects both of these variables: i.e. the physical risk from climate change is expected to affect the level and/or the growth rate of GDP;

• extreme weather can impact global food production leading to food price inflation;

• higher CO2 taxation and related technological adjustments may lead to increased costs for companies, with increased inflation.

• impact on prices and expectations

• adjust aggregate demand conditions

• climate changes is a new challenge for CB

The natural rate of interest r* is the rate consistent with stable inflation when the economy is growing at its trend.

The two most powerful channels seem to be the impact on productivity and uncertainty.

Overall, climate change can be expected to drive productivity down, at least until the transition is completed, putting further downward pressure on r*, except in the case of ‘strong’ green growth that would boost productivity.

Physical risks can damage commercial property and production equipment at a higher speed than under current climate conditions (a higher obsolescence rate)

Transition risks might also turn productive investments into stranded assets

The effect of climate-induced replacements on total factor productivity is unclear:

higher economic tail risk and uncertainty triggering a higher risk premium

reduced willingness to invest and a greater propensity to save; two factors that lower the natural interest rate. This increases the propensity to save and the demand for low-risk assets, two factors that can reduce

Productivity and uncertainty seem to be the most powerful channels for the policy space.

Overall, climate change can be expected to drive both down, at least until the transition is completed, putting further downward pressure on r*, except in the case of ‘strong’ green growth that would boost productivity. Yet this is subject to nuances and qualifications.

Central banks should preserve their ability to deliver on their price stability mandate against materialisation of climate risks.

• Central banks must assess, and where appropriate adopt, appropriate risk management measures to protect their balance sheets against emerging climate-related financial risks

While governments have the primary responsibility and tools for addressing climate change, the ECB’s mandate requires the ECB to assess the impact of climate change and to further incorporate climate considerations into its policy framework, since physical and transition risks related to climate change have implications for both price and financial stability, and affect the value and the risk profile of the assets held on the Eurosystem’s balance sheet.

• climate related aciton plan

• incorpotation (Einbindung)

• policy assessments (politische Bewertungen)

• change design of monetary policy

Consider relevant climate change risks when reviewing the valuation and risk control for assets mobilised as collateral. This will ensure that they reflect all including those from climate change.

CB may not set climate policies autonomously, but only contribute to their attainment by supporting the relevant Union policies

• Such action may not, however, prejudice the primary objective of price stability.

• If support to the general economic policies in the Union conflicts with price stability, the Treaties require primacy to be given to price stability.

Turning to a greener economy projected to result in the fossil fuel reserves (around 80%) becoming stranded resources, 90% of Africa’s coal reserves

For government revenues and spending in some of the poorest countries reliant on fossil fuel revenues.

Poor countries are less insured, lower ratings, harder to get loans, banks have mor risk, loans get more expensive