Climate Risks Facing the Financial Sector and the Role of the Regulator

This blog is written by Oswaldo López and Edgar Salinas.

At the end of 2020, the U.S. Federal Reserve (the Fed) announced that it would be joining the Network for Greening the Financial System (NGFS), an organization created in 2017 by the world’s leading central banks and global supervisors in an effort to understand and define mitigation measures for climate change risk on the financial system.

Although the news went mostly unnoticed, it is of significant importance, not only because the Fed was—up until recently—the only entity among the world’s main central banks that had not joined the NGFS, but because of the differentiating experience it brings as regulator of the world’s largest economy and the hub of global capital markets.

According to observations by the scientific community, there is sufficient evidence to show how human activities have contributed to climate change over the past 50 years, which has resulted in various, long-term alterations, including rising sea levels and global average temperatures, loss of polar and continental ice, among others.

Specifically in Latin America, the Intergovernmental Panel on Climate Change establishes a correlation between year-to-year weather changes and the El Niño phenomenon, with widely documented impacts that progressively aggravate the region’s vulnerability. For example, El Niño is associated with dry conditions in northeastern Brazil, the northern Amazon region, the Peruvian-Bolivian highlands, and the Pacific coast of Central America. On the other hand, La Niña is associated with heavy rainfall and flooding in Colombia and drought in southern Brazil.

Other phenomena such as coastal erosion and flooding due to rising sea levels pose significant risks to a population of more than 600 million people living along Latin American and Caribbean coastlines, which could also have an impact on urban and port infrastructure. Faced with these challenges, the Paris Agreement was created in 2015, in an effort to help stabilize the increase in global average temperature and boost adaptability to and resilience against the adverse effects of climate change, while promoting development with low greenhouse gas emissions and greater financial flows compatible with a resilient development trajectory.

To better illustrate the relationship between the financial sectors, climate risks and their potential impacts, the Financial Stability Board—an entity responsible for assessing vulnerabilities affecting the financial system and identifying regulatory actions—presents a revealing discussion in its Report on the Implications of Climate Change on Financial Stability, explaining in detail the channels through which climate risks, whether physical and/or transitional, could affect the financial system:

• The physical risks impact the value of assets, both those stemming from extreme weather shocks, and those caused by chronic deterioration. These risks can result in losses for insurance companies, banks and other financial institutions in a variety of ways.
• Transitional risks derive from the potentially rapid devaluation that would affect a series of greenhouse gas-intensive assets, due to the effects of the transition to a lower emission-intensive economic model.

In addition to the academic definition, there are various situations happening at the global level and are a clear manifestation of these risks. In terms of physical risks, noteworthy is that insurance payouts due to cyclones, hurricanes, storms, and floods occurring acrossdifferent regions around the world hit a record high in 2020. Among the transitional risks are, for instance, the UK's decision to suspend direct government disbursements toward foreign fossil fuel exploitation operations, as well as the recent executive decrees by the United States government seeking the suspension of drilling and extraction of gas and oil on federal lands, and the legislation of the German parliament, which proposes to phase out carbon use from the country’s energy grid by the end of 2038. While these decisions seem distant, either geographically or in level of government, these options should be examined in detail in order to determine whether they could reflect new market conditions for which our region should be prepared.

Distortions caused by climate change in various production chains, whose actors are linked to the financial sector through loans, securities, capital markets instruments, etc. add uncertainty about the borrowers’ repayment capacity, return on investment and asset value. The current situation poses a challenge to the fulfillment of the fundamental functions of central banks, which are expected to face new threats to the financial system, arising from potentially irreversible losses that borrowers could suffer from climate change, as well as the impacts on the price stability target, especially in cases where central banks lack credibility, where persistent relative price shocks on agricultural goods (caused by frequent extreme weather events) can go as far as to erode medium-term inflation goals.   

While the interest of central banks in the financial risks imposed by climate change is an important step, there is still a long road ahead towards defining specific regulations to mitigate these risks. Like macroeconomic risks, climate risks should be incorporated into portfolio risk weighting models in order to establish an appropriate capital supply and support scheme. 

Given the above, climate change poses an unprecedented challenge for economic policy-makers and, in particular, for financial system regulators. The following initiatives are among the many in which progress must be made, particularly in the short term:

• Continuing efforts to incorporate climate risk assessment into financial institutions’ oversight models, with the purpose of defining climate risk mitigation schemes (capital reserve levels, provisions, etc.). This definition could reduce potential shocks on medium- and long-term private investment decisions
• Increasing inter-agency resources devoted to the analysis of climate change threats to the financial system, beyond the individual assessment carried out by each bank. The challenges of collecting data, measuring and estimating financial risks related to climate change are many. Increased research efforts on this topic will help overcome this barrier.
• Promoting greater spaces for collaboration between financial regulators, environmental macroeconomists and climate experts to establish a knowledge base tailored to the realities of the region. In the face of the complexity of climate change challenges, it is important to foster a dialogue among stakeholders, in order to leverage synergies, capabilities and experiences of actors who usually do not have spaces for discussion. 

In this context, international development banking could play a relevant role by providing spaces for discussion, relying on their extensive network of contacts with environmental authorities and specialists, and by funding studies and research work that improves our understanding of climate change risks on financial markets.