Thematic Tags: Macro financial risks and macroprudential supervision

Low-Carbon Transitions and Systemic Risk

The low-carbon transition has been cited by policymakers as a potential driver of systemic risk that could lead to financial instability and negative macroeconomic outcomes. Transition risk refers to the economic and financial risks associated with a disorderly transition to a low-carbon economy. Policymakers have highlighted that the systemic nature of transition risk could lead to an adverse impact on financial stability. In particular, several have warned of the potential for a transition-driven ‘Minsky moment’ whereby a disorderly transition leads to a sudden collapse in asset prices. This work draws on the frameworks of central banks and academic studies to identify the channels through which an adverse shock can lead to a realisation of systemic risk. Systemic risk can be defined as the risk of a shock that has negative externalities on economies and financial systems via networks. This risk can be realised when a large number of financial market participants are impacted simultaneously or when a sectorspecific shock leads to contagion and feedback loops that amplify the impact. The realisation of systemic risks can also be more likely when the source of risk is not well understood. This makes it inherently challenging to identify them ex ante, but therefore important to consider the multiple possible channels and work through their potential implications.
The report then considers the channels through which systemic risk could materialise under a low-carbon transition. The main sources of risk identified in the context of a low-carbon transition are a sudden downward repricing of carbon-intensive (orlow-carbon) assets and energy price shocks. The repricing of assets would lead to losses for those directly and indirectly exposed. Feedback loops can also amplify the initial losses and have a negative impact on the wider economy. Further, a disorderly transition could lead to an energy price shock which has a large negative impact on economic growth. Within these main sources, we outline the detailed transmission channels for systemic risk stemming from overlapping portfolios, lending between financial market participants, and the interaction between the financial system and the real economy.
While there is an extensive literature on systemic risk, the literature on systemic risk in relation to a lowcarbon transition is still in early stages of development. Since the financial crisis, there has been a growing emphasisin the literature on assessing the systemic financial risk triggered by unexpected shocks, such as the bursting of the subprime mortgage bubble in the US. Approaches include the development of marketbased indicators that capture the build-up and materialisation of systemic risk, general equilibrium models and stress testing frameworks. Whilethe literature focussing on transition risk in particular is more limited,
there are studies which have employed networks approaches to estimating systemic risk in the context of a low-carbon transition.
We identify the main gaps in existing methodologies for estimating the systemic risk posed by a low-carbon transition and recommend areas for future research. First, further data collection is required to better assess
the exposure of assets to transition risk. In addition, policymakersshould work to develop more comprehensive climate-related stress testing exercises, with more of a focus on second round impacts.
Where possible, these exercises could draw on historical events with similar characteristics, such as a large swing in energy prices. Further, the development of more comprehensive approaches such as multi-layered
models of financial and production networks, and frameworks that include both the impact of rising and declining industries have the potential to improve the assessment of systemic risk.

Case Studies of Environmental Risk Analysis Methodologies

10 September: Over the last few years, the idea that environment‐related risks can strand assets in different sectors of the global economy has become much more widely accepted. The threat of stranded assets, particularly from climate‐related physical and transition risks, has spurred work by financial supervisors and central banks. NGFS members have announced new supervisory expectations and climate stress tests to help improve the solvency of individual financial institutions, as well as the resilience of the financial system as a whole. We know we must act. But financial institutions and their supervisors are still at an early stage
in developing and deploying suitable datasets, models, and tools. We urgently need better data and analysis in order to properly measure and manage exposures to environment‐related risks.
There are barriers that need to be overcome and we know what these are: poor availability of consistent, comparable, and trusted data; costs of data and accessing resources to conduct analysis; missing standards and norms that hinder the use and flow of data; a lack of transparency into data and methods used, resulting in a trust deficit among users; and underdeveloped internal capabilities to analyse and interpret data and analysis to aid decision making.
The NGFS is committed to helping the entire global financial system quickly overcome these barriers, so environment‐related risks can be properly measured and managed, and that is why we are excited to see the publication of our first NGFS Occasional Paper, Case Studies of Environmental Risk Analysis Methodologies. This anthology contains dozens of examples of environmental risk analysis in practice, with chapters written by a wide range of different research providers and practitioners. The methods and tools they describe can be used by wide range of different financial institutions, including banks, asset managers and insurance companies. While we are not recommending any particular service or provider, the point of the paper is to showcase the scale and pace of innovation currently underway.
The Occasional Paper is relevant to all central banks, NGFS members, as well as non‐members. It offers valuable insight into the state of environmental risk analysis and many technical details that will be helpful for financial institutions and supervisors. The fact that it showcases the adoption of environmental risk analysis by some financial institutions in the world will also serve as an important inspiration for many others to follow suit. The views expressed in the Occasional Paper are those of the individual authors, and do not necessarily reflect the views of the members and observers of the NGFS.

Preface by Frank Eldson and Dr Ma Jun

Climate-related financial policy in a world of radical uncertainty: Towards a precautionary approach.

Climate-related financial risks (CRFR) are now recognised by central banks and supervisors as material to their financial stability mandates. But while CRFR are considered to have some unique characteristics, the emerging policy agenda for dealing with them has largely focused on conventional market-based solutions. The current policy emphasises information gaps that prevent the accurate assessment of market risk. The assumption is that these gaps can be remedied via disclosure, transparency, scenario analysis and stress testing, which will enable markets to self-correct. We argue this approach is misguided as CRFR are characterised by radical uncertainty and hence ‘efficient’ price discovery is not possible. Instead, a ‘precautionary’ policy approach is proposed. Since climate change poses a severe and potentially irreversible threat, a lack of scientific certainty as to its exact nature or timing should not prevent regulatory action to mitigate its impact. Such an approach justifies fully integrating CRFR into financial policy, including both prudential and monetary policy frameworks. Central banks and financial supervisors can and should actively steer market actors in a clear direction — towards a managed transition — to ensure a scenario that minimises harm to the financial system and the wider economy in the future.

Assessing forward-looking climate risks in financial portfolios: a science-based approach for investors and supervisors

Climate risk is a new source of financial risk characterized by deep uncertainty, non-linearity, and endogeneity. Neglecting these characteristics leads to a severe underestimation of potential financial losses and gains. We present the CLIMAFIN methodology designed to help investors and financial institutions to address this challenge and to embed climate risk into pricing models and stress-tests. The method builds on the Climate Stress-test by Battiston et al. (2017), which has become over the years a reference tool for academics and practitioners. CLIMAFIN allows to translate forward-looking climate transition scenarios into financial shocks and to provide investors and financial supervisors with scenario-adjusted risk metrics and models (e.g. Climate Value at Risk, Climate Spread, Climate Stress-test). The chapter describes the technical details of the methodology and some recent policy applications carried out in collaboration with leading financial institutions