Central banks ‘need new mindset’ for climate
The increasingly obvious threat of climate change is leading central banks into new territory, as they begin to analyse the risks it poses to the financial system. It is stretching them intellectually and posing new questions about how they interpret their mandates, and whether they can lead society or must travel at its pace.
One of the newest sustainable finance organisations has become perhaps the most talked about: the Central Banks’ and Supervisors’ Network for Greening the Financial System.
Founded by eight central banks in December 2017, it now has 46 members and nine observer organisations, including the Bank for International Settlements, IMF, World Bank and European Investment Bank.
“The main thing happening today is a change in mindset,” said Luiz Pereira da Silva, deputy general manager of the BIS (pictured). “The community of central banks uses linear financial models — with climate change you have to apply a mindset of sudden jumps, a non-linear model.”
Central banks and regulators are the most powerful — and many say the most conservative — actors in financial markets. Their response to climate change has not really begun yet. But when it does, market participants expect it to be very influential. However, it is not clear yet how much central banks are willing to use their power or take a leadership role.
In April, the NGFS published its first comprehensive report, A Call to Action, which made six recommendations. Central banks should integrate climate risks into financial stability monitoring and micro-supervision, consider sustainability in their own investing, bridge data gaps, build awareness and knowledge sharing, achieve robust and internationally consistent climate and environment-related disclosure, and support the development of a taxonomy of economic activities.
"Our objective is now to turn this into something more concrete and actionable," Morgan Després, deputy head of financial stability at the Banque de France and head of the NGFS secretariat, told GlobalMarkets.
The group has three workstreams: supervision, chaired by Ma Jun of the People's Bank of China; macrofinancial, which considers climate change's effects on the economy, led by Sarah Breeden of the Bank of England; and scaling up green finance, under Sabine Mauderer of the Deutsche Bundesbank.
In Washington on Friday October 18, the NGFS launched its latest document: A Sustainable and Responsible Investment Guide for Central Banks’ Portfolio Management.
The report, prepared by De Nederlandsche Bank, the Banque de France and the Bundesbank, tackles how central banks can put their money where their mouths are. "For us it's important to lead by example," said Mauderer. "What can we do as investors? Is it possible for us to invest sustainably, and if so, how do we do it?"
The Guide is both a survey of what central banks are doing and a handbook.
Central banks often have up to four kinds of asset portfolio. Their policy portfolios — such as bonds held to carry out monetary policy — and third party assets are subject to fairly tight investment constraints. It is with their “own funds” and pension portfolios that they have gone further in responsible investing — but in several different directions.
Norges Bank, which also invests Norway’s $1.1tr sovereign wealth fund, has a highly structured and public approach motivated by considering environmental, social and governance issues to optimise the risk and return performance of its holdings in 9,000 companies. Within a strict governance framework, it also makes some ethical exclusions.
The Banque de France, by contrast, sees itself as an impact investor. It aims, with the €19bn of assets it wholly controls, to contribute to the global response to climate change.
The authority central banks carry, and the clarity of the document, mean it could influence other investors. Norges Bank's exclusion list is already followed by many other fund managers.
But it is the NGFS’s other two main areas of work — supervision and scenarios — that most interest the outside world. Central banks are trying, through the group, to construct a discipline completely new to them: “measuring”, as one central banker called it, the risks of physical damage and economic transition on financial institutions they regulate, and on the financial system. Because climate change has never happened before, economic theory holds no answers.
Banks cannot use statistical models based on past experience, but must imagine scenarios of what climate change might be like in future.
By April, the NGFS hopes to have produced a guide containing three or four scenarios for how climate change might affect the economy, to use in risk forecasting.
“The private sector say they need a harmonised approach to scenario analysis,” said Després. “What we publish will not be a standard but will give guidance.”
The guide is likely to include scenarios in which society starts early on the low carbon transition and therefore this is relatively smooth; one in which there is a late start and more disorderly progress; perhaps a mix of the two and one in which the 2C target is not met.
By summer 2020, the NGFS will follow up with a handbook of supervisory practices.
But amassing the data and knowhow for a thorough analysis of banks’ portfolios takes time. It may be another two years before many central banks begin stress-testing banks.
As for how supervisors will use their knowledge when they have it, one central banker said: “Oh, we are not thinking about policy at this stage,” adding that the risks must first be “measured”.
Meanwhile, it is clear how much banks are lending to oil companies, and how much to wind farms. And climate change is not waiting for central banks to catch up.
Asked by GlobalMarkets why central banks could not use their supervisory powers now to ask banks what their plans were to align with the Paris Agreement target of 1.5C of global warming, Kristalina Georgieva, managing director of the IMF, conceded that they were not moving fast enough. “Central banks are learning to walk and chew gum at the same time,” she said. “We need to recognise that action cannot be delayed, but when we put policies in place they have to be evidence-based and data-driven.I think we are not moving fast enough. What gives me hope is that less than two years ago eight institutions said 'we have a huge problem' – today we have 46.”
In answer to the same question, Després said he agreed that “we can’t afford to wait for the perfect data”. But he added: “Central banks cannot solve these problems by themselves. What we can do is try to have the right tools, so the market can price climate risks properly. The ultimate objective is to allow investors and market participants to price risk.”
Pereira da Silva said: “The transition has to be a manageable transition, otherwise we could end up with too rapid a transition to a greener economy, which might cause a Minsky moment [sudden collapse of asset prices].”
He added that it would be hasty to think a central bank could become the climate arbiter of last resort, when government, the private sector and individuals also needed to contribute.
He is concerned about the risk of central banks doing something that would cause a collapse in the finances of the oil sector. "We want everything to move faster - we have kids asking us 'what are you doing? Leaving us with a mess.' But it has to be part of our job to ensure all our actions are done in a sustainable and effective way."
Després said that on two of its six priorities, the NGFS would need help from external agencies. "We need a taxonomy not only for green but brown activities - those clearly exposed to climate change," he said. This is not covered by the Taxonomy of Sustainable Economic Activities the EU is preparing. Asked who should produce this, Despré said: "I understand defining [the EU Taxonomy] was quite a challenge. I don't think member states or the European Commission want to initiate work on defining brown activities. But ultimately it probably is their job to do it."
The second area where the NGFS needed help was environmental disclosure rules for companies.
On whether capital risk weightings should be tweaked to favour green assets, Després said: "The view of the vast majority of members is that prudential regulation should be risk-based. If we have evidence there is a risk differential [between green and brown] then maybe we can reflect that in regulation."