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Green finance supervision: let’s not obsess over data

By Jasper Cox
25 Aug 2020

Financial supervisors and regulators are too preoccupied with collecting research and data on environmental threats to finance and the economy, rather than simply using their own judgement and other tools at their disposal.

Data may be the new oil, but sustainable finance practitioners have long hoped it will also help nudge investors out of the black stuff.

Many believe that finance’s failure to get to grips with the threat of climate change is in large part due to a lack of hard numbers and modelling. They think that if the market manages to price in the shift to a low-carbon economy, and rising temperatures and sea levels, capital will flow towards climate solutions and adaptations.

Central banks and financial supervisors have, in a similar vein, started to engage in efforts to measure the impact of climate change.

Morgan Després, deputy head of financial stability at the Banque de France, said last October that while “we can’t afford to wait for the perfect data”, “the ultimate objective is to allow investors and market participants to price risk.”

Després is also head of the secretariat for the Network for Greening the Financial System (NGFS), an organisation at the forefront of supervisors’ tentative foray into the climate change debate.

This group of central banks and supervisors says its purpose is “to help strengthen the global response required to meet the goals of the Paris agreement and to enhance the role of the financial system to manage risks and to mobilise capital for green and low-carbon investments in the broader context of environmentally sustainable development”.

Much of its work so far has focused on research and models. Take its latest batch of publications from June, for instance:

It delivered a paper detailing a range of potential scenarios for climate emissions and policy, aiming to provide a “common reference framework for central banks and supervisors”.

It also looked at the potential impact of climate change on monetary policy and made a number of suggestions for further research and analysis. And it produced a separate list of research priorities.

Analysis like this is useful, but its benefit is overstated and it is insufficient.

At the beginning of the year, central banks dived into action as markets freaked out about the coronavirus pandemic. Led by the US Federal Reserve, they threw the kitchen sink at the problem: opening swap lines, ramping up purchase programmes and releasing capital constraints for banks.

Overall — especially taking into account the magnitude of the crisis and urgency required — their interventions were successful, even if you can debate the merits of certain aspects of the policies.

Given the uniqueness of the crisis and the uncertainty about the disease itself, the central bankers could not rely on a model telling them with perfect accuracy how far economic activity would fall, or exactly what the probability of deflation was. Instead, they recognised that a storm was hitting and used their own expert judgement.

This point is made by three researchers — Katie Kedward, Josh Ryan-Collins and Hugues Chenet — in a new paper for the UCL Institute for Innovation and Public Purpose. The paper tackles how supervisors and central bankers should think about threats to and from the environment, beyond climate change. One of these dangers is animal-to-human disease transmission.

These threats link up with each other and with climate change; they do not co-exist separately. The authors point out: “Climate-induced flooding, wildfires and droughts accelerate habitat and biodiversity loss, while these in turn are key contributors to climate change. The degradation of critical carbon-sink ecosystems, such as forests, wetlands and peatlands, reduces the planet’s carbon-absorbing capacity.”

With little historical data and many intertwining parts, stress testing and modelling for climate change and broader environmental threats clearly run up against limits. This is particularly the case when the question of how the transition to a low-carbon economy plays out — and let’s hope it does — is also unknowable. This transition depends not just on economic trends but election results, social movements and much more. To put it another way, how do you model for Greta Thunberg?

Officials do recognise these sorts of constraints. A paper for the Bank for International Settlements in January (co-authored by Després) pointed out that “integrating climate-related risk analysis into financial stability monitoring is particularly challenging because of the radical uncertainty associated with a physical, social and economic phenomenon that is constantly changing and involves complex dynamics and chain reactions”.

But they need to get on with using other mechanisms for making finance more sustainable, as the authors of the UCL paper argue. They can rely on more basic rules of thumb about what type of activity is too dangerous, in collaboration with scientists.

They can also become more active players in sustainable finance, through for example greening eligibility criteria for quantitative easing and collateral. If central banks and supervisors feel unable to do all this within the constraints of their current mandates, the rest of us should lobby politicians to change those mandates, while respecting their institutional independence.

In becoming more interventionist, finance’s umpires will make mistakes — but acting too cautiously is ultimately more reckless.

By Jasper Cox
25 Aug 2020