CLIMATE CHANGE: FINANCIAL RISK, ASSESSMENT AND MITIGATION TOOLS
Tackling climate change is critical to ensuring a healthy planet as it also makes good economic sense, writes Eniola Adetola
Climate change has become the greatest priority and it poses significant risks to global financial systems and those that rely on them. Reducing uncertainty about the pace of climate change and policy, as well as improving entities’ ability to accurately assess risk, will be imperative to mitigating climate financial risks now and in the future.
Tackling climate change is critical to ensuring a healthy planet, but it also makes good economic sense. Studies have shown that the social gains far outweigh the costs of climate financing. There is now a sizeable and growing body of literature providing quantitative estimates on the “social cost of carbon.” This measures the incremental harm from climate change caused by additional carbon emissions. And evidence now shows that avoiding emissions and moving to renewables would result in significant social benefits and an overall net gain for society.
Potential risks to energy transition could amplify risks to the financial system. The energy-related repercussions from the war in Ukraine, is an opportunity to look towards phasing out fossil fuel subsidies in emerging markets and developing economies and also begin to embrace or invest in clean and renewable energy. A delayed or disorderly climate transition could magnify the risks to the financial system.
There are eight financial market tools that support sound assessment and mitigation of climate-related financial risks by different entities. Such as the central bank and financial regulators.
One, the pressing needforstructural reforms to minimize the impact of climate change on the financial system and proper implementation ofclimate-related financial policies by policymakers: There is a direct positive relationship between climate protection and economic performance and financial stability. Therefore, there is a need to properly implement sound financial policies and carry out structural reforms to minimize the impact of climate change on the financial system. One of the reasons this has been stalled in the developing markets, is the lack of proper financing to affect structural changes.
Two, the Central bank and financial regulators must systematically integrate climate risk assessments into their financial stability frameworks: When climate risks are deemed material and systemic importance exists, special attention will be needed to ensure the evaluation of how climate risks amplify and transmit risks to the financial sector. They should therefore ensure that climate-related risks are adequately captured in their processes. Where these risks are assessed as being material and likely to threaten financial stability, they should intervene early.
Three, building capacity in the area of climate-related financial risks. Preserving financial stability is the core mandate of financial authorities, in other to ensure that climate-related risks are adequately captured in their supervisory/regulatory processes, capacity building in the area of climate-related financial risks should be prioritized.
Four, central bank’s mandates and balance sheets: There is a need for an analytical assessment of the impact of climate change on central bank operations, governance framework, policy-setting framework, and financial stability. It should be incorporated within the mandate of the central bank, how environmental sustainability objectives should influence central bank operations and the use of monetary policy tools, and integrate sustainability considerations into the central bank’s balance sheets.
Five, disclosure is the process by which an entity reports its assets, liabilities, and risks. Financial regulators across the world generally require disclosures of key financial information from public and private companies to help investors make informed decisions. In a climate context, this could include greenhouse gas emissions (both direct and in its supply chain), exposure to climate impacts such as flooding and wildfires, and management practices to address physical and transition risks. As the climate changes, these metrics are becoming increasingly relevant for investment decisions; for example, an investor in a State with stringent climate policies should be less inclined to invest in a business with relatively high carbon emissions.
Six, establishment of climate information gathering structure. Identifying and assessing climate risks, and enabling informed investment decisions require a robust information structure around climate risks. The information structure should consist of reliable and high-quality data, a harmonized and consistent set of climate disclosure standards; and principles to align investments to sustainability goals. Implementing a climate information gathering structure may serve as the foundation to develop sustainable finance markets in emerging and developing economies. In this regard, current standard-setting work should fully take into consideration, the difficulties in data collection in emerging markets, while ensuring that company-level disclosures are mainstreamed across these economies.
Seven, climate Stress testing is a standard tool used by financial institutions and regulators to assess financial resilience in adverse scenarios such as a recession. This approach is recognized as an essential tool to analyze exposure to climate-related financial risks. Most proposed and ongoing climate stress tests take the form of a scenario analysis, which applies a set of forward-looking scenarios that capture plausible future states of climate change and climate policies and evaluate a financial entity’s performance in them. The Network for Greening the Financial System (NGFS), a network of several dozen central banks and financial supervisors, has issued official guidance on climate scenario analysis for financial regulators. As of spring 2022, adopters of climate stress testing include the Netherlands, France, the European Central Bank, Canada, Australia, and the United Kingdom. US financial regulators, such as the Office of the Comptroller of the Currency (OCC) and the Federal Reserve, are also developing principles and infrastructure for climate stress testing.
Eight, mobilization of both public and private funds towards climate financing: Local, national, or transnational financing drawn from public, private and alternative sources of financing that seek to support mitigation and adaptation actions that will address climate change are needed because large-scale investments require funds to significantly reduce emissions. We need to understand the potential avenues to scale up private financing to mitigate climate risks, which is required to develop sustainable finance markets. Access to finance continues to be a barrier in many economies. In some economies, climate finance flows need to increase by four to eight times until 2030, according to the latest estimates from the Intergovernmental Panel on Climate Change.
Momentum is continuing to build on climate financing and other initiatives, but we need to act now to ensure the necessary frameworks are in place in the years ahead. Everyone must play a role in scaling up work and effort on climate-related financial risks and climate finance.
Adetola is a
Senior ESG consultant,
IPMC Ltd
