Tue, Jan 07, 2020 - Page 9 News List

Climate change presents central banks with plenty of questions

By Willem Buiter

Central banks confronted with the issue of climate change face a number of questions: Should monetary policymakers (and other financial regulators and supervisors) focus on the implications of climate change for financial stability? Should they treat climate change as a potential threat to their ability to pursue their macroeconomic mandates of full employment and/or price stability? Should mitigating the adverse consequences of climate change become an explicit monetary-policy objective?

In considering such questions, it is important to remember that two distinct types of financial risks are associated with climate change. The first includes the transition or mitigation risks that come with a successful shift to a lower-carbon future. For example, climate-mitigation and green-energy policies could result in stranded assets — namely, fossil-fuel reserves — that would sharply decline in value, owing to a fundamental change in demand wrought by legislation, regulation, taxation, technology, tastes and so forth.

The second class of financial risk concerns a failure to address climate change effectively. There are physical risks associated with adaptation to a higher-carbon future, including the destruction of real commercial and natural assets, as well as human capital. A wide range of natural disasters would threaten infrastructure, other privately and publicly owned structures, land, and water resources. And the heightened risks to people of injury, death, or lost earning potential could have adverse financial consequences not just for those directly affected, but also for insurance providers and other parties.

At least since the signing of the 2015 Paris Agreement, financial regulators and supervisors have been aware of the risks that climate change poses to financial stability. The UK’s Prudential Regulation Authority now pays close attention to the potential impact of climate change on the insurance and banking sectors, and, along with the UK Financial Conduct Authority, it has modified supervisory and regulatory frameworks accordingly.

Likewise, the Financial Stability Board’s Task Force on Climate-related Financial Disclosures has developed recommendations for building climate resilience that now enjoy wide support. And the Central Banks and Supervisors Network for Greening the Financial System, created in 2017, offers regular recommendations for how banks and other financial institutions can address climate-related financial risks.

As this proliferation of regulatory and advisory initiatives suggests, climate risks could have a first-order impact on the ability of monetary authorities to pursue their traditional macroeconomic objectives. Extreme manifestations of climate change could depress aggregate demand and potential output significantly, unpredictably and over extended periods of time.

In recent decades, central banks have faced few significant stagflationary challenges (low economic growth coupled with high inflation) beyond the familiar case of oil-price shocks. But that could change if the adverse supply and demand-side effects of climate change become more frequent and severe. Moreover, the broader climate risk could mean that the monetary-policy time horizon (typically two to three years) will have to be extended to allow for low-frequency, high-impact, and persistent climate shocks.

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