INSPIRE commissions best-in-class, independent global scholarship and analysis on key aspects relating to climate change and environmental sustainability to inform the work of the NGFS, its workstreams, and its members, in addition to the wider community of central bankers and financial supervisors.
Commissioned through open calls for research proposals, our projects are organised into six broad themes designed to complement the major priorities for greening the financial system identified by the NGFS, namely:
- Microprudential supervision, disclosure, climate change, and environment
- Macroprudential supervision, financial instability, climate change, and environment
- Evaluating risk differentials based on environmental factors
- Monetary policy, direct and indirect monetary instruments, climate change, and environment
- Climate change, the environment, and sovereign risk
- Assessing the real-world effectiveness and impact of central bank and supervisory policies in greening the financial system.
This final theme ‘Assessing the effect and impact of policies’ cross-cuts the scope of our entire portfolio.
In Spring 2021, we partnered with the Green Finance Platform to launch the Sustainable Finance Policy Effectiveness Working Group Learn More
From Covid-19 to climate change and nature loss: how can a precautionary financial policy framework coordinate monetary, prudential and fiscal policies to address long term challenges?
In the face of climate-related financial risks, the Bank of International Settlements in its ‘Green Swan’ book demonstrated the importance of coordination between green fiscal policy, prudential regulation, and monetary policy. Such coordination must be underpinned by a shift in intellectual framework to facilitate financial policymaking under unprecedented global threat situations.
Aligned with this assessment, we propose to develop the Precautionary Financial Policy (PFP) framework, to address the dual issues of policy coordination and the need for an underlying paradigm shift. The PFP framework provides the theoretical justification for more ambitious financial policy interventions, in the face of the radical uncertainty characterizing long-term and potentially irreversible risks such as those posed by climate change and massive biodiversity loss.
The project will develop the PFP framework as a new paradigm that could support greater coordination between monetary, prudential, industrial, and fiscal policies (henceforth financial-fiscal) in the face of emerging climate- and nature-related financial risks. In particular, we will examine:
- How this approach may provide a more coherent alternative than the ‘market neutrality’ principle in facilitating such coordination, in light of the recent European Central Bank’s declarations questioning this principle, and
- How the PFP could help to deal with the problem of differing time horizons across policy spheres, institutions, and mandates that also mitigates against policy coordination.
The research will involve analysis of historical examples since the 1930s up to and including the most recent policy responses of financial-fiscal policy coordination and expanded institutional purpose to address Covid-19. We will develop a typology of financial-fiscal policy coordination and use this to formulate concrete policy recommendations in terms of institutional setup and governance.Show Less
The impact of climate change and policies on the balance of payments and central banking in commodity-exporting developing countries
We assess the implications of climate change and policies for monetary policy mediated through their impact on the balance of payments. We examine transitional and physical risks in developing countries where the influence of balance of payments on monetary policy is shaped by the countries’ strong dependence on primary commodities, on top of their larger vulnerability to external financial shocks in comparison with developed economies.
We use two case studies of middle-income countries to conduct this research. We analyse the experience of Nigeria, an oil-dependent commodity exporter, during three sharp declines of international oil prices (the global financial crisis of 2008, the fall in oil prices in 2014, and the fall in 2020 due to the C-19 pandemic). This will serve as an example of the potential impact of transitional risks such as decarbonisation policies and divestment strategies. Regarding physical risks, we take the case of Argentina, a country with a significant share of agricultural products in its export basket. The country is experiencing more frequent and prolonged droughts and floods in main agricultural regions.
The study conducts a mixed methodology approach. The focus will be on export performance, exchange rate volatility, and the implications for monetary policy design and implementation, capturing direct (trade balance) and indirect effects (exchange rate and financial stability) of developments in commodity exports and prices. Immediate effects are assessed with the help of event studies and time series econometric analyses. These quantitative results are triangulated with qualitative data derived from semi-structured expert interviews with central bankers.Show Less
Optimal Climate Change Mitigation through Green Quantitative Easing and Fiscal Policy
We address the question of how green quantitative easing could complement governments’ toolkit for climate change mitigation. In our setup, green quantitative easing refers to a given outstanding stock of bonds held by the European Central Bank and its portfolio allocation between a clean and dirty sector of production. Our key research question is how the central bank can contribute to an optimal inter-generational sharing of the burden of climate change policies in comparison to, or in combination with, fiscal mitigation policies.
We develop a quantitative overlapping generations model in which households consume and allocate their savings and their work efforts between a clean and dirty production sector. A reallocation of the central bank portfolio toward the clean sector increases the capital stock employed for production in that sector relative to the capital stock in the dirty sector. This triggers a relative increase of labour demand in the clean sector and a relative expansion of output. Through this mechanism, the central bank can thus influence relative production across the two sectors in the economy. We then contrast this policy with fiscal policy measures to mitigate climate change. We will explore whether the central bank can improve the economic allocation beyond what is thus achieved through fiscal policy.
Holding constant the balance sheet of the central bank enables us to focus on the portfolio reallocation mechanism. However, it limits the interaction between fiscal and monetary policy in the model. As a next step, we extend the model by an explicit notion of money and the introduction of a distortion that requires bond purchases by the central bank, which will enable us to study the effects of an expansion of central bank bond holdings and of climate policy interactions.Show Less
Building a macro-financial integrated-assessment model for ordered transitions and fiscal-monetary policy interactions
Assessing the impacts of climate change-related physical and transition risks on the financial system and the macroeconomy is one of the most urgent and prominent needs to support climate policy design. However, the modelling toolbox for the assessment of these risks is currently rather scant.
We contribute to filling this gap by developing a macro-financial model that brings a detailed energy sector into a macroeconomic agent-based model with heterogenous banks and cross-sectoral exposures. The advantage of the proposed framework is twofold: It builds on two consolidated models in their respective domains (macro-financial and integrated assessment modelling) and includes a representation of both micro-level indicators of economic activity (e.g., insolvency rates, mark-ups, productivity dispersion, non-performing loans) and macro-level indicators (e.g., output growth, volatility, unemployment, public debt). Crucially, the macroeconomic properties will emerge indirectly from the decentralised interactions of individual agents and will possibly show non-linear and threshold effects (e.g., due to contagion).
After calibrating the model, we structure the project around two main applications. First, the model will be used to assess how the transition pathways of major emission/socio-economic scenarios and the associated changes in the climate would affect macroeconomic fundamentals and financial stability. Our results will add a macro-financial perspective to the scenario narratives. Second, building on previous work of the project team, we are testing a variety of climate-related fiscal, monetary, and macroprudential policies, with the aim of studying whether a target to physical or transition risks from climate change could hide trade-offs or double-dividends.Show Less
Quantifying the impact of green monetary and supervisory policies on the energy transition
As we transition our economies to a low-carbon path, climate-related transition risks to the financial sector pose a challenge to policymakers in their policy design. Central banks can play an essential role in facilitating a successful transition by directing the funds needed to achieve this transition in a timely manner and thus reducing systemic risks. However, any intervention by central banks should be evaluated across sectors and across scenarios in order to guarantee effectiveness, efficiency, and coherence with fiscal policies.
Our methodology is scenario analysis based on a modified Computable General Equilibrium model, which allows us to capture feedback loops across sectors, along with tracking the change in prices and quantities following an exogenous change in policies, technologies, or consumer preferences. Moreover, in order to capture both risks and opportunities associated with the transition process, our model distinguishes between clean and dirty subsectors. It also uses sector-specific capital stocks, which allows us to differentiate the cost of capital across sectors and scenarios. The model output includes quantitative effects of exogenous policy change on cash flows, return on invested capital, asset values, price levels, inflation, and many other variables across modelled sectors and scenarios. Such information can be used to stress test investment portfolios and financial stability under different monetary, supervisory, and fiscal interventions. We believe that our approach is an innovative one that contributes to answering key questions about the impacts of central banks’ policies and operations on the costs of different pathways for the energy transition, through both the performance of the financial system and the possible changes in the real economy.Show Less
The Financial Geography of Green Finance Policy: Evaluating Policy Effectiveness across over 50 countries
In the past decade, over 390 finance policy initiatives aimed at greening the financial sector have been spearheaded by various public authorities around the world. So far, scholarship has offered insights into how traditional environmental policy such as carbon taxes, emission trading schemes, or low carbon R&D subsidies impact green financing, innovation, and financial performance. However, we still know surprisingly little about the impact of green finance policies on the real economy and the financial sector itself. In particular, we run major knowledge and policy deficits in managing climate risks in primary capital markets. Furthermore, we still have a limited understanding of the effectiveness of green finance measures and how they interact with other existing environmental policy regimes across countries; particularly how they might be undercut by subsidy regimes towards emissions-intensive industries that governments pursue in parallel.
We address this gap by conducting an in-depth mapping of green finance policies and traditional environmental policy instruments across more than 50 countries. We propose to quantitatively analyse the impact of extant green finance policies in shifting capital towards green solutions and away from emission-intensive activities. These objectives will be achieved via a three-pronged approach:
- Analyzing the largest datasets on sustainable finance policy initiatives and instruments,
- Interviewing NGFS members, and
- Analyzing a comprehensive global dataset of syndicated loans, equity, and bond issuances.
Our research seeks to inform and enhance the capacity of central banks and financial supervisors to implement effective green capital market policies that are well-adapted to broader policy and subsidy regimes. In addition, we will discuss the implications of more stringent capital market regulation for just transition outcomes.Show Less
Climate change and central bank asset purchases: An empirical investigation for the euro area and the UK
The aim of this project is to provide the first integrated analysis of how the corporate asset purchases of the Bank of England and the European Central Bank can become climate-aligned, as well as the impact that this could have on economic/financial factors and emissions. We explore the implications of two different approaches for the incorporation of climate issues into central bank asset purchases: (i) the ‘climate footprint’ approach whereby the asset purchases are adjusted based on the climate performance of the bond issuers and (ii) the ‘climate risk’ approach in which the recalibration of asset purchases relies on the exposure of companies to climate risks under different climate scenarios.
For each approach, we explore several options that include both the ‘tilting’ of purchases and the exclusion/inclusion of corporate bonds. In the case of the ‘climate footprint’ approach, the adjustment of purchases relies on the combined use of backward-looking and forward-looking metrics about the emissions of companies and other environmental factors. In the ‘climate footprint’ approach, the adjustment is based on the credit risk that the bond issuers face under the NGFS climate scenarios. We use econometric techniques to investigate the potential effects of the different policy options on the climate performance of bond issuers.Show Less
Assessing the effectiveness and impact of central bank and supervisory policies in greening the financial system across Asia
The Paris Agreement established the importance of aligning financial flows with a pathway toward low-carbon and climate-resilient development. In response, central banks and financial supervisors have scaled up sustainable finance measures and are increasingly important stakeholders in climate governance. Due to the contemporary and evolving nature of the topic area, there is a knowledge gap regarding the efficacy of adopted measures and their environmental, social, and economic impacts. It is unclear whether sustainable finance measures are having the intended impact on the financial system and the real economy. Analysis is required to understand:
- The full details of sustainable finance measures that have been implemented;
- The rationales and processes underpinning their adoption; and
- The effectiveness, efficiency, and equity of adopted measures, from the perspective of both financial institutions and supervisors.
We address this knowledge gap, focusing specifically on Asia, where many countries have adopted sustainable finance measures. Asia has global relevance as it contains many countries with the largest or rapidly increasing greenhouse gas emissions levels. We employ a sequential research design, utilising both quantitative and qualitative methods to collect primary data. Key elements of the research will be two written surveys with central banks and supervisors, and banking institutions, respectively, as well as detailed follow-up interviews with both groups.
Our research improves understanding of the progress made toward aligning financial systems and flows with the Paris Agreement. It will highlight cases where measures taken by central banks or supervisors have led to measurable positive outcomes, in terms of contributing to the transition to a low-carbon and climate-resilient economy or managing transition and physical risks. It will provide recommendations on data gathering by central banks to enhance their evaluation of the effectiveness of sustainable finance measures. It will provide policy guidance so countries can improve the design and implementation of existing and new measures, thereby enhancing the capacity of central banks.Show Less
Implications for Emissions, Investment, and Inflation
Over recent years several instruments for green central bank monetary policy have been proposed but little to no modelling rigour has been applied to further substantiate the debate. We draw on theoretical modelling and numerical simulation to assess two specific proposals of green monetary policy: the greening of central bank collateral frameworks, and targeted green refinancing operations. We hope to deepen our theoretical understanding of these instruments and quantify their impact on the economy and environment. To do so, we draw on formal modelling that can account for cumulative emissions, differentiated investment (based on carbon emissions), economic growth, monetary policy, and inflation.
Our model will be the first to integrate all of these five aspects which are all essential to our research question. The inclusion of monetary policy is self‐explanatory. However, the final requirement, inflation, is often neglected within climate policy analysis. Within the context of green monetary policy, inflation becomes particularly important as it is the principle aim of modern central bank mandates and climate change might create “cost‐push” or “demand‐pull” inflation.
In order to inform policymakers of the potential effects of green collateral frameworks and green refinancing operations, we propose including inflation and monetary policy into a dynamic general equilibrium model that includes a banking model, differentiated sectors (based on carbon emissions), and conventional climate polity. In addition to observing the effects of green monetary policy on emissions and investment, this model would also allow us to analyse the potential trade‐off between climate change mitigation and inflation, which might have large-scale ramifications for social welfare.Show Less
Does the green property reduce bank loan risk?
To address whether credit risk is lower for banks’ green assets, we perform a granular analysis on the risk implications of the green property of bank loans in the context of a comprehensive international bank loan dataset, Thomson Reuters’ DealScan. We address three key research questions related to the discussion of the adoption of a ‘green supporting factor’:
- Is the risk of banks’ green loans lower globally?
- If the risk is lower, what are the possible channels/mechanisms through which the green property exerts this effect?
- How can the green impact be calibrated into the green supporting factor and how can the empirical effect of the green supporting factor on banking systemic risk be quantified at the country level?
We conduct an empirical analysis, utilising the detailed global loan-level data from the LoanConnector database. Based on the empirical findings, we compose a single-period model to analyse the impact of a ‘green supporting factor’ (GSF) on bank risk profiles. We use the calibration to address our third research question and to gauge the extent to which a GSF changes bank loan risk at the end of the period where the equilibrium is reached. The calibration results quantify the impact of a GSF on bank loan risk profiles and the stability of financial markets as a whole.
Our expected findings will provide a systematic understanding of the linkage between green loans and their associated risk, which will help policymakers to quantify a green supporting factor and to understand the sensitivity of this factor to varying lender and borrower characteristics.Show Less
Estimating the impact of physical climate risks on the probability of default (PD) of mortgage loans in the coastal cities of China
Climate-related physical risks, such as typhoons, floods, and heat waves, will result in considerable damages and losses to the real economy and to the financial sector that provides financing for economic activities. Against this backdrop, the international financial community has been calling for attention and actions to integrate climate-related physical risks into financial decision-making by financial institutions. To manage environmental and climate risks, the primary step is to quantify these risks. However, literature that quantifies the implication of climate-related physical risks for the financial sector is very limited.
We present an analytical framework for measuring the impact of climate-related physical risks on the default risk of bank loans. We applied this method to quantify the increase in the probability of default of mortgage loans for properties in China’s coastal cities, caused by the increased intensity and frequency of typhoons under four commonly used climate scenario defined by the Intergovernmental Panel on Climate Change.
The preliminary findings of this INSPIRE study show that future typhoon events exacerbated by climate change along the coast of China could potentially lead to a considerable increase in the probability of default for mortgage loans, with a possible accumulation of incremental probability of default of more than 5%. This analytical framework can also be applied to many other scenarios of environmental and climate risk analysis for banks if the data required are available, such as impacts of floods and water shortages on credit risk of loans to sectors that are sensitive to such risks.Show Less
The Optimal Mix of Monetary and Climate Policy
This research theoretically investigates the mix of monetary and climate policy and provides insights for central banks that are considering their engagement in the climate change issue. The “climate-augmented” monetary policy is pioneeringly proposed and studied.
Our research method is an extended Environmental Dynamic Stochastic General Equilibrium (E-DSGE) model. The basic DSGE setting is in line with the standard New Keynesian framework. The “Environmental” features are introduced by incorporating the greenhouse gas emissions from production, their negative externality on productivity, and the climate policy that controls emissions, i.e., cap-and-trade or carbon tax.
Based on the model, we preliminarily find the following results:
- The process of developing monetary policy should consider the existing climate policy since it is a factor that can influence price level and inflation.
- The reaction coefficients in traditional monetary policy rule can be better set to enhance welfare when climate policy is given. This provides a way to optimise the policy mix.
- If a typical-form climate target is augmented into the monetary policy rule, a dilemma could be created. This means that it has some risks for central banks to care for the climate proactively by using the narrow monetary policy (interest rate).
Working Group on Banking Supervision and Sustainable Development in the Americas
Banking regulations are known to have substantial leverage on the real economy for the simple reason that finance permeates everywhere. By the same token, they are a suitable instrument for improving the preparedness of the real economy for climate change. We convene a working group of prominent practitioners from among the collectivity of bank supervisors and regulators in the Americas, along with recognised experts in the field in order to review the state of practice regarding the incorporation of climate change into micro prudential regulatory frameworks.
For purposes of ordering the discussion, existing and potential practices will be grouped into four categories:
- Those where the authorities provide finance by instruction.
- Those where the authorities provide incentives for desired types of finance.
- Those where the authorities reduce financial risk by socialising potential losses by means of insurance, direct payments, or exceptional access to citizens’ own assets.
- Those where systems are set up to prevent, contain, and abate negative externalities.
To assist the working group’s deliberations, we will provide reference documents on existing practices, as well as on plausible modifications in existing regulations that can have important positive impacts for climate change and adaptation. The working group will also be asked to discuss the feasibility of specific innovations for making regulations more climate-friendly, and to review potential obstacles, barriers, and resistance to the implementation of such potential change. The document emerging from the working group’s deliberations will provide policy recommendations and, where appropriate, a further research agenda.
Working Group members:
- Evasio Asencio, Commissioner Owner, Comisión Nacional de Banca y Seguros, Honduras.
- Carolina Benavides-Piaggio, Senior Capacity Development Officer, FMO, The Netherlands.
- Keron Burrell, Head Methods, Analysis and Quality Review Department Bank of Jamaica.
- Ethel Deras, President Comisión Nacional de Banca y Seguros, Honduras.
- Rafael Del Villar Alrich, Advisor to the Governor Banco de México.
- Alan Elizondo, Director General, FIRA Mexico.
- Mariana Escobar, Head Sustainable Finance Group, Superfinanciera Colombia.
- Daniel Gomez Santeli, Risk Manager, Comisión Nacional de Banca y Seguros, Honduras.
- Kemar Hall, Assistant Director (Acting) Policy, Research, Methodology, and Development Department Bank of Jamaica.
- Patricia Moles, Advisor, Banco de México.
- Sheriffa Monroe, Director Policy, Research, Methodology, and Development Department Bank of Jamaica.
- Carlos Alberto Moya, Consultant
- Carmen Navarro, Senior Social and Environmental Officer, FMO, The Netherlands
- Ángel Odogherty Madrazo, Co-General Director Sector Intelligence, FIRA, Mexico
- Pascual O’Dogherty, Secretary-General, Association of Banking Supervisors of the Americas, Mexico
- Daniel Schydlowsky, Boston University Global Development Policy Center, USA
- Guilherme Teixeira, Manager Sustainable Finance, SITAWI Finanças do Bem, Brazil
What are the options for sustainable crisis response measures?
We investigate response measures that could be deployed by central banks and other financial institutions in the context of the Covid-19 crisis in a way that contributes to sustainability. Originally conceived to develop a framework for policy responses for the next financial crisis, the project concept was updated to consider policy options for both the stabilisation and the recovery phases of the current crisis. We review and assess existing and novel proposals and present a menu of post-crisis management tools for central bankers, financial regulators, and governments, with an evaluation of their sustainability-related risks and benefits, taking particular note of the environmental and social equity dimensions. The project will consider the suitability of different response options in Europe, Asia, and North America based on available knowledge about tools used in prior crises and in this crisis so far. Policy options for different areas will be discussed in a series of closed and public webinars, and policy recommendations will be published in a policy brief series that will form the basis of an overall summary report.Show Less
Adjusting sovereign credit ratings to reflect climate change
Financial markets face increasing pressure to factor climate risks into decision-making. Enthusiasm for ‘greening the financial system’ is welcome, but a fundamental challenge remains: Investors lack the necessary information. This creates a potential conflict of interest and information asymmetry: Sovereigns want cheap access to capital and have an incentive to downplay climate risk, while investors want to manage climate exposure but do not know how much risk they face. Without a standardised framework and regulatory requirement for disclosing climate risk, organisations face little incentive to provide such information accurately to investors.
Existing climate risk disclosures are rare, ad hoc, voluntary, unregulated, and generally based on internal assessments rather than climate science. Credit ratings agencies are key intermediaries between investors and investment opportunities, serving an important role by rating the creditworthiness of potential investments. They use established and published methods to combine publicly available information with an ‘inside look’ to measure the ability of the issuer to repay its debt obligations. Ultimately, their role is to help reduce information asymmetries, overcome conflicts of interest, and provide investors with standardised information about risk.
We examine how well ratings agencies capture climate risks in ratings. We investigate how well the financial system factors in climate-related risk and makes such information available to investors. First, using historical evidence, we determine whether past ratings have factored in observed climate-related losses. Next, we combine forward-looking climate models with the ratings methodology from a major credit ratings agencies to compare sovereign creditworthiness in a world with climate change, versus a counterfactual world without warming (in which temperatures are held constant at their 1980-2010 average). Finally, we mobilise our extensive network in finance, climate science, and economics to develop a provocative position piece on the state of green finance and future priorities.Show Less
Management of Climate Risks in the Financial Industry of a Resource Based Economy: A Canadian Scenario Analysis
Although some studies exist on how the financial industry is affected by climate risks and how it might manage them, no such studies exist for a country with an economy that is mainly based on carbon-intensive resources, such as oil, gas, and mining. We conduct a scenario analysis based on an impact matrix that uses both physical and transition risks to model impacts on the financial portfolio of Canadian chartered banks. We will complement findings about climate-related risks and opportunities in Europe, Asia, and Africa that are different from climate change-related risks to North America and that are in countries with different regulatory frameworks.
Our research will be based on a formative scenario analysis and an impact matrix will be created based on the Intergovernmental Panel on Climate Change climate scenarios and climate scenarios for Canada. Based on different data sources, we will conduct a MICMAC analysis (a system of multiplication of matrices applied to the impact matrix) to calculate both direct and indirect impacts on Canadian banks’ financial risks. The expected results will help policymakers in countries with carbon-intensive economies to create financial policies, regulations, and supervision regimes that could be applied by central banks and other financial regulators to mitigate climate risk for the financial industry without creating otherwise significant negative impacts for these countries’ economies.
The results of this INSPIRE research will help banks to implement strategies to reduce their exposure to climate-related financial risks. Consequently, negative impacts on the Canadian financial industry could be avoided. This is important given that the Canadian banking sector is dominated by five chartered banks that are similar with regard to their businesses.Show Less
Climate Risk and Central Bank Refinancing Operations
We analyse the impact of central bank refinancing operations on bank lending, investment in the real economy, and financial stability. In particular, we assess whether and how much climate risk-adjusted refinancing operations that apply differentiated interest rates based on the climate risk exposures of bank loans would improve financial market outcomes in terms of lower-carbon investment.
We base our analysis in the context of a financial market failure, where firms and banks underestimate climate risks. For that, we use a model where underestimating climate risks on the side of firms causes under-investment into climate risk mitigation (CRM), and underestimating climate risks on the side of banks induces excessive lending to firms exposed to climate risk. Misallocation of resources in the real economy and bank defaults induce a welfare loss in the economy. Banks’ lending decisions can be steered through climate risk-adjusted refinancing operations by the central bank, which, in turn, reduce the misallocation of resources in the real economy. This outcome is reinforced by a subsidy to companies for CRM. Specifically, the interest rate policy adopted by the central bank is such that banks’ cost of refinancing depends on the allocation of loans to more and less risky firms. This way the central bank can correct the belief-distorted lending decisions. The socially optimal allocation is achieved by a combination of subsidies and targeted refinancing operations, i.e., fiscal and monetary policy are complementary.Show Less
Using credit risk as an empirical basis for the development of Brown taxonomies
Green taxonomies are designed to highlight investment opportunities for a transition to a low-carbon economy. While useful for many purposes, they fail to capture risks. Banking supervisors are now pressing for the development of dirty taxonomies as a way of quantifying potential stresses in the financial system associated with climate change.
Our project considers how integration of climate risk assessment and credit risk assessment can form a transparent and replicable methodology for accomplishing this goal. A useful dirty taxonomy should be able to identify assets and firms whose adaptive capacity limits their ability to navigate physical and transition risks. The analysis will be forward-looking and rely on scenarios. Perhaps most crucially, the outputs of the taxonomy should be clearly traceable to major input assumptions. In contrast to green taxonomies, one cannot say a priori what is dirty. Much depends on an unknowable set of policy interventions, technological developments, and localised events that will occur in the future.
To gain a transparent and replicable dirty taxonomy, we will proceed by organising asset- and firm-level impacts into three major categories: adaptation risks, mitigation risks, and natural capital risks. These risks will be analysed within an integrated assessment model that we have combined with a structural economic model. We adopt three transition scenarios that are examined across three time horizons. Testing our methodology on firms in the European energy sector, the outputs establish the materiality of risk factors. Tracing clearly from inputs to outputs allows for changes in credit quality to be observed for individual firms. The work will reveal whether events such as the weakening of coal producers and the utilities sector over the past decade are idiosyncratic, or representative of a ‘new normal’ under a transition to a low-carbon economy.Show Less
Do the UN SDGs affect sovereign bond spreads? Initial evidence
The traditional relationship between sovereign bond spreads and macroeconomic fundamentals appears to be weak since the financial crisis. In search of additional determinants, scholars shifted their attention toward intangible factors related to ESG dimensions. Country ESG ratings are used to measure a country’s sustainability level, but often solely provide information about a country’s policy toward these intangible factors. We believe that the SDGs can provide a better measure for sustainability of a country. The strength of the U.N. SDGs is that all goals are interlinked; governments are unable to cherry-pick their favourite goal. Unlike ESG ratings, the SDGs can be seen as a measure of the transition of the country toward full sustainability and are therefore output- and future-oriented. In addition, the SDGs are a direct measure of a government’s pledge to achieve social inclusion and environmental protection by 2030.
We use the dataset of the latest Sustainable Development Report, which includes an overview of countries’ performance on the SDGs to investigate the impact of SDG performance on sovereign bond spreads. We will use a broad range of low- and high-income countries to capture government bonds issued in different currencies. We are interested in the governments that are unprepared will increase the risk of unforeseen future SDG-related government expenses. An increase in government expenditures will negatively impact a government’s budget and its likelihood to repay its debt. Investors may demand to be compensated for this higher perceived country risk, influencing borrowing costs for governments.Show Less
Supervision beyond the business cycle: A framework for long-term financial supervision
Financial supervisory mandates are interpreted to ensure financial stability ‘over the business cycle’ (three to five years). New risks are challenging this paradigm, as they manifest themselves both over longer time horizons and as secular, one-directional shocks. We have designed this exploratory conceptual project to identify potential mechanisms and levers financial supervisors can mobilise in order to ‘supervise the long-term’ and reframe their mandate to cover more long-term risks.
Current financial policy and supervisory analysis falls into two categories. In the first category, financial policy analysis seeks to identify potential levers within the mandate to supervise risks over the business cycle (e.g., capital requirements) or support societal goals. The second category involves the development of tools to analyse the financial materiality of long-term risks (e.g., climate scenario analysis). Missing within this paradigm is the ‘adapter’ that allows for the integration of the second category of analysis into mainstream supervisory frameworks. As a result, stress tests looking out to 2030 are intellectually satisfying, but remain largely theoretical exercises.
We seek to begin to fill this gap by suggesting a framework for what long-term financial supervision could look like that would allow for the integration of these long-term risk assessments, as well as the steering of policy levers beyond business cycle risk management. This requires a review of both existing and potential new policy instruments, as well as more general questions over how such policy could work (including related to the arbitrage between short-term and long-term risks).
The primary output of our research will be a discussion paper focused on two central questions:
- What are the instruments to enhance the supervision of long-term risks?
- How might governance and mandates need to change to support the supervision of long-term risks?
Greening the Eurosystem Collateral Framework
The collateral framework of the Eurosystem is a crucial component of the eurozone financial system, since it determines the way by which commercial banks obtain central bank liquidity and affects the credit conditions facing the non-financial sector. However, in its existing form, it does not capture climate risks and is not conducive to the decarbonisation of EU economies. Our analysis shows that carbon-intensive sectors are overrepresented in the list of eligible corporate bonds: 59% of the eligible bonds have been issued by carbon-intensive sectors, while the contribution of these sectors to the EU gross value added and employment are 29% and 24%, respectively.
We investigate how the Eurosystem collateral framework can become climate-aligned using two different approaches. In the first, ‘climate footprint’ approach, haircuts and bond eligibility are adjusted based on the climate impact of bond issuers, which in our analysis is captured by using both backward-looking and forward-looking metrics. The second, ‘climate risk’ approach, relies on the use of the NGFS climate scenarios for estimating the financial effects of climate risks on bond issuers. For both approaches we explore several policy options and show the implications for the haircuts per sector, the haircut-adjusted outstanding amount of bonds and the weighted average carbon intensity of the list of eligible bonds. We also analyse the channels via which a climate-aligned collateral framework can affect the climate performance of companies. We show that the ‘climate footprint’ approach can be more conducive to decarbonisation compared to the ‘climate risk’ approach, without reducing the amount of corporate bonds that euro area banks can post as collateral.Show Less
Climate-related Financial Policy in a World of Radical Uncertainty: Toward a Precautionary Approach
Climate- and environment-related financial risks, both transition and physical, are characterised by radical uncertainty. This means conventional backward-looking probabilistic financial risk modelling is not fit for purpose in dealing with this uncertainty. While scenario analysis and stress testing to some extent recognise the uncertainty problem, they remain based on assumptions that are subject to significant uncertainty and do not sufficiently justify action in the short term, despite widespread recognition of the risks posed by inaction.
To address this lack of certainty, we have proposed the adoption of a new policy framework, the Precautionary Financial Policy (PFP) approach, to deal with the financial stability risks. This framework draws on two well established concepts: first, the ‘precautionary principle’ commonly adopted in environmental management policies to avoid passing certain thresholds, and second, modern macroprudential policy. PFP justifies fully integrating climate- and environment-related financial risks into financial policy, including both prudential and monetary policy frameworks. This helps to justify preventative actions now in order to mitigate the potentially catastrophic financial and economic damages created by climate change, and shape financial markets in a clear direction toward a preferred net-zero carbon future.
In terms of implementation, we propose the comprehensive integration of climate risk into capital adequacy requirements, monetary policy operations (including asset purchases and collateral criteria), quantitative credit controls and credit guidance, and the enhancement of financial system resilience. Policymakers adopting a precautionary approach should be aware of the likely short-term trade-off between efficiency and resilience, and likely resistance from market actors with shorter-term time horizons. There is a need to ‘learn by doing’ in this new environment.Show Less
Central Banks’ Mandate in Green Credit Guidance: Beyond Prudential Regulation
The success of the Paris Agreement in enhancing the implementation of the U.N. Framework Convention on Climate Change and strengthening the global response to climate change in part owes to the integration of finance considerations. A legally binding document ratified by 187 parties, Article 2.1c of the agreement stipulates financial flows must be made consistent with a pathway toward low greenhouse gas emissions and climate-resilient development, and Article 9 sets out provision of financial resources. While financial flows directed toward climate change mitigation and adaptation are increasing, they remain significantly below those required under the Paris Agreement. This points to the need to leverage private sector finance in order to mitigate this funding gap.
This research assesses the potential role for central banks in implementing green credit guidance for commercial banks to mobilise the much-needed climate finance. Given the enormity of the green financing gap, central banks arguably have a role to play in redirecting private sector capital flows from high-carbon sectors to low-carbon sectors. We critically assess the various objections against green credit guidance by central banks and argue for a promotional role. We collect and analyse primary data through key stakeholder interviews at select central and commercial banks and supplement the findings through document analysis of banks’ financial reports and other relevant academic literature. The empirical findings highlight the concerns and views of the affected stakeholders.Show Less
Prudential instruments to scale up green finance: simulating the impact of green prudential regulations in an agent-based macro-financial model
The existing financial regulatory framework made notable progress in detecting, assessing, and containing systemic risks. However, a closer investigation of existing prudential instruments shows that several regulations under Basel III contain an intrinsic ‘carbon bias’ that creates barriers to aligning the financial sector with sustainable transition roadmaps. In particular, on the one hand, existing capital and liquidity regulations underestimate the risks related to so-called ‘green assets’ and potentially undermine the resilience of the financial system. On the other hand, they limit the bank capital available for green assets and favour dirty assets.
By considering the current state of the art, we highlight the lack of a comprehensive framework that is needed to analyse the impact of green prudential regulations. Thus, our research project aims to build such a framework and study how prudential regulations could deal with risks to financial stability arising from climate change. By building on theoretical research we have published in the past, this project aims to develop a tool to assess the implications of the implementation of different green prudential instruments under different macrofinancial scenarios. We will resort to the agent-based modelling approach (to build up a macrofinancial model) populated by a heterogeneous production sector, heterogeneous consumers, a banking sector, and a central bank.
This research will help in understanding, on the one hand, whether climate-related macroprudential tools lead either to market distortions or financial instability. On the other hand, it could assist in detecting which are the main factors that hinder or contribute to the effectiveness of such instruments.Show Less
Assessing forward-looking climate risks in investors’ portfolios: from theory to practice
Climate-related financial risk is characterised by endogeneity and deep uncertainty. The inadequacy of standard financial risk approaches to deal with these dimensions is a challenge for a smooth transition to a low-carbon economy. Across the last five years, we have developed a stream of work addressing this issue using a framework for climate financial risk management under uncertainty. This framework has been applied to the analysis of climate risk of financial portfolios, in collaboration with financial supervisors.
With this project, we aim to mainstream such a framework in microprudential and macroprudential policies implemented by financial supervisors and financial institutions belonging to the NGFS. We have engaged with relevant NGFS stakeholders through bilateral meetings, focus groups, and international conferences to co-develop narratives related to two main questions:
- How can the available scientific knowledge on climate change mitigation be best applied to identify relevant scenarios of disorderly low-carbon transition?
- What are the implications of scenario selection for investor decisions and for financial stability?
We found there is great importance to foster central banks’ and financial regulators’ understanding about:
- Climate change mitigation scenarios (e.g., those co-developed and used by the NGFS), their limits and opportunities, and the conditions to use them to inform climate stress tests exercises;
- The endogeneity of climate-related financial risks in climate stress test; and
- The conditions for finance to be a driver or a barrier to the transition.
Sovereign risk and climate change
We investigate how climate risks impact sovereign credit risk and debt sustainability and assess the implications from a financial regulation and central banking perspective. We address the following two sub-questions:
- Through which channels can climate-related risks affect sovereign risk and how important are their respective impacts?
- What are the regulatory and supervisory implications for financial supervisors and central banks?
First, we develop a conceptual framework that characterises the transmission channels between climate risk and sovereign risk, stressing the importance for financial regulators and central banks to integrate these risks into their operational frameworks in achieving their mandated objectives. Second, building on this conceptual work, we assess the climate-sovereign risk nexus for the 10 member countries of the Association of Southeast Asian Nations (ASEAN), a group that includes four NGFS members (Indonesia, Malaysia, Singapore, Thailand).
We find climate change can have a material impact on sovereign risk through direct and indirect effects on public finances. Furthermore, it raises the cost of capital of climate-vulnerable countries and threatens debt sustainability. All branches of government will have to address climate-related risks and must climate-proof their economies and public finances or potentially face an ever-worsening spiral of climate vulnerability and unsustainable debt burdens. Monetary and financial authorities will have to play crucial roles in analysing and mitigating macrofinancial risks. Our research provides insights into policy coordination between the central bank and government in order to optimise public debt management.Show Less
The stochastic impact of extreme weather events
In this project, we assess the impact of abnormal weather shocks on the global macroeconomy. Extreme weather events are random in size and location. We use stochastic trials to generate a distribution of weather shocks across the world and use NiGEM, a large macroeconometric model, to quantify the impact of these shocks on the macroeconomy. NiGEM links countries through trade and non-trade channels, and as such, a shock that impacts a single country or region will reverberate to other parts of the world. Our project captures the direct and the indirect impact of extreme climate events. Our analysis shows that extreme weather events cause economic volatility and that spillover effects magnify these events. We show that international spillover effects from trade and financial markets are important transmission channels, particularly for small open economies that are densely populated.
Our research has implications for at least two areas of central bank policy. The most proximate area of intervention is through the stress-testing framework where financial institutions should, in our view, disclose the risks posed by extreme weather events. Central banks can also adjust capital buffers to specifically account for assets that are exposed to such events and intervene in a more granular way using lending metrics such as the loan-to-value ratio. Second, where possible, the central banks can adjust the haircut imposed on the collateral that it accepts in its monetary policy refinancing operations by taking into account the financial risk posed by extreme weather events.Show Less
The Effects of Mandatory Environmental, Social and Governance (ESG) Disclosure Around the World
In recent years, due to the dramatic increase in demand for ESG information to prompt sustainable growth, many countries and jurisdictions have issued regulations that mandate firms and financial institutions disclose their ESG situations and activities. But what are the real impacts of such mandatory ESG disclosure regulations on financial markets? We address this question by examining the financial stability of firms in 44 countries around the world over a sample period of 2000 to 2017.
To assess the stability of a firm, we measure the volatility of equity return and the likelihood of stock price crashes. Using multivariate regressions, we find equity return volatility is lower after mandatory ESG disclosure, and within this, systematic and idiosyncratic volatility are also significantly lower. We find stock price crash risk declines after the enforcement of mandatory ESG disclosure.
Our findings support calls for mandatory introduction of ESG disclosure requirements. In particular, stock exchanges should increase their ESG disclosure policies, as we show that mandatory disclosure improves the information environment. Moreover, our findings on financial stability are of interest to central banks and the enactment of mandatory ESG disclosure enhances the stability of the financial market by improving the ESG informational environment.Show Less
Environmental and Social Risk Management in Brazilian Banking: From an Environmental and Social Management Structure to Climate Scenario Analysis Development
The Central Bank of Brazil is taking encouraging steps for greening the country’s financial system. In 2014, the Brazilian National Monetary Council issued Resolution 4327, a principle-based resolution that required all Brazilian financial institutions to develop an Environment and Sustainability (E&S) management system with a comprehensive scope.
Three years later, Resolution 4557 was published, requiring risk management and structure for capital management of Brazil’s financial institutions, and in 2020, the Central Bank of Brazil joined the NGFS. In this study, we assess and benchmark the impacts of the Central Bank of Brazil’s Environmental and Social Risk Management policy by conducting interviews with Brazilian large- and medium-sized public, private, and development financial institutions. Central Bank of Brazil staff were also interviewed to gain clearer understanding that what kind of methodologies, tools, and practices would be better to assess financial institutions based on Brazilian Monetary Council (CMN) Resolutions 4327 and 4557.
Based upon our findings, we developed a self-assessment tool that will provide a checklist to help banks grasp the concepts behind the principles-based approach of the national E&S regulatory framework. We found Tropicalisation of international benchmarking from oversight bodies and market players (mainly those related to Taskforce on Climate-Related Financial Disclosures recommendations) is a way to improve E&S risk management process in Brazil (and potentially in other Latin American countries). Similarly, since 2020, high-level management engagement has enabled the Central Bank of Brazil to begin a better integration of E&S and climate issues into its regulation and supervision.Show Less
Low-carbon Transitions and Systemic Financial Risk
The transition to a low-carbon economy has been cited by policymakers as a potential driver of systemic risk that could lead to financial instability and negative macroeconomic outcomes. Most notably, Mark Carney’s ‘Tragedy of the Horizons’ speech warned of the potential of a transition-driven ‘Minsky moment’ whereby a disorderly process leads to a sudden collapse in asset prices.
We identify the channels through which a transition shock could lead to a systemic disruption. These include the downward repricing of carbon-intensive (or green) assets and a reduction in emissions-intensive production. We outline the approaches developed by existing studies to assess systemic risk, including the tracking of transition risk indicators such as bank exposure to emissions-intensive sectors, stress-testing frameworks, and network modelling approaches.
There is still much uncertainty on how to best measure the level of systemic risk posed by the transition, and therefore the size of this risk. Paradoxically, the realisation of systemic risks is more likely when the source of risk is not well understood. It is therefore important to consider the possible channels and work on their potential implications.Show Less
The Role of Monetary Policy Under a Low-carbon Transition
We assess the implications for monetary policy action under a zero-carbon transition. Via a more stringent climate policy, the transition can result in both demand- and supply-side shocks. We seek to provide insights on the potential monetary policy responses to a climate policy shock by modelling the economic impacts using the multi-country, multi-sector model of the global economy, G-cubed. We draw on literature to define robust rules and we will consider rules that are uniform across regions, as well as differing rules in order to better replicate real-world monetary policy responses.
Our results suggest that a carbon tax consistent with 2° C of warming leads to a clear monetary policy trade-off, with higher inflation and a negative output gap. For the majority of countries, the impact on inflation outweighs that on output growth in the short term, whereas in the long term, the impact on output growth dominates, leading to a reduction in policy rates. The policy rate remains permanently lower once the shock has dissipated, suggesting that a persistent tax on carbon will lead to lower potential output and a lower neutral interest rate. Such a large tax on carbon would need to be accompanied by a large increase in productivity to offset the impact on potential output and long-term interest rates.
The shocks required to achieve ambitious targets lead to large negative impacts on emissions-intensive sectors. It’s difficult to assess how the transition to low-carbon energy sources will occur whilst also capturing the impacts on the rest of the economy.Show Less