Fixing the tragedy of the horizons
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Fixing the tragedy of the horizons

Central banks have become integral to the fight against climate change in financial markets. Participants now expect them to wield their immense influence through many avenues of their work — economic analysis, metrics, supervision, investment and even monetary policy.

None of this is explicitly in the mandate of any central bank. In the past four years, first a few central banks and now many have rethought and reinterpreted their mandates, in light of the realisation that climate change poses an existential threat to our way of life — and hence, inevitably, to financial and price stability.

The main channel for that rethinking has been the Central Banks’ and Supervisors’ Network on Greening the Financial System (NGFS), formed in December 2017 by institutions from eight countries, which now has members from some 70 jurisdictions.

Morgan Després (pictured) has been centrally involved in that process, as head of secretariat for the NGFS from its inception until June 2021, when he returned to a full time post at the Banque de France as director of strategy.

He talked to Jon Hay about central banks’ responsibility in the face of climate change, and what they can do to help. Crucial goals, he argues, are to tackle the financial markets’ tendencies to misprice climate risks and to concentrate on the short term — the failing known as the tragedy of the horizons.


GlobalCapital: Do you think central banks have a responsibility to mitigate climate change?

Yes, clearly they do. At the end of the day it depends on their mandate, but almost all have a financial stability mandate. In the NGFS we made the case that climate change is a source of financial risk, therefore it falls squarely within the mandate of central banks. 

When we started the Network there were a lot of sceptics saying ‘is this really part of your mandate?’ We turned the question round — if you’re not taking climate risk into consideration then you’re not fulfilling your mandate. It seems there is now a very broad consensus on that.

GlobalCapital: For central banks to consider climate risk, does it have to be a risk to financial stability within a certain horizon — within three years, for example?

That is the question of the tragedy of the horizons. Sometimes you hear that climate change will materialise in the medium to long term. But you can see some impacts now, especially physical risk. A few years ago there was an intense drought in Europe and the level of the Rhine fell very low. Because of it, some boats couldn’t go up river and transport coal, gas and oil, and the impact was very clear on commodity prices. 

Transition risk may materialise in the next five to 10 years, but some impacts are there already.

GlobalCapital: Should central banks try to fulfil that responsibility for mitigating climate change in all areas of their activity — or only in some?

You have to be consistent. If you’re telling the banks and insurance companies you supervise that they need to be able to flag their exposures to climate risk and do something about them, then you also need to practise what you preach and reflect it in your own risk management approach.

Many central banks are reflecting this in their own investments — it’s about consistency and being credible.

The recent NGFS publication on reflecting climate risk in central banks’ monetary policy operational frameworks also shows that some actions are possible on that front as well.

GlobalCapital: What are the most powerful things central banks can do to protect society and the economy from climate change?

The prerequisite behind the creation of the NGFS was the question of risk mispricing. A few years ago we had the intuition that climate risk was not being priced appropriately. Therefore investors in their risk-return analysis were financing sectors exposed to climate risk, because their returns were overestimated and their risks underestimated.

Therefore we wanted to help market participants by providing tools so they would be in a position to price climate risk properly. 

That is the way to fix the tragedy of the horizons, have scenario analysis and the last link is carbon pricing, which is in the remit of governments. It’s part of the equation to have this repricing fixed.

To bring this about, we are carrying out climate stress tests, issuing supervisory guidance, requesting things to happen in firms’ internal governance.

We can lead by example, disclosing our own exposures. The Banque de France did that two years ago in our non-monetary portfolio. We can promote research — we have very strong relationships with academics.

GlobalCapital: Within prudential policy, there could be two approaches. There is a systematic one, of changing risk weightings and capital requirements — there has been a lot of talk about green supporting factors and brown penalising factors. And there is a more informal, specific one — you have a conversation with the CEO of a bank and say ‘let’s talk about your climate risk; what are you going to do about it?’ Which do you think is better: the more gradual, mechanical approach or the more individualised one?

It’s probably a matter of sequencing. Before moving to calibrating risk weights or brown penalising factors, you need to be able to measure risk and calibrate the quantum of exposure. 

You need to get to a point where analytically you have a pretty good idea of how these risks are going to affect probability of default and loss given default. In my view, we are not there yet. 

So it definitely makes more sense now to have private conversations, because the level of exposure of banks does vary very much, according to their business models, sectoral exposure and geographical exposure. Some supervisors are having these conversations already. It’s a very interesting first step. Then later, it might move to the policy space.

GlobalCapital: Do you think by emphasising the importance of measurement, and waiting for perfect data, there is a risk of wasting time?

I couldn’t agree more. If we wait for perfect data the transition will never happen.

There is probably a trade-off. I remember when we tried to do this exercise in France we struggled to identify the exposures because there was no brown taxonomy — we had to decide what sectors were more prone. Of course there are obstacles, but that doesn’t mean it’s not possible. We may need more manpower and more manual processes. It’s an obstacle to uniform, standardised stress testing.

Nevertheless, we are making great progress. At the Green Swan Conference at the beginning of June we had many leading figures from central banking and finance speaking on these issues.

Now we really have a political willingness to do something. But we need to move from willingness to commitment. I hope we will do so at Cop 26. Being willing is good, but it’s not sufficient.   

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