Bank for International Settlements

The green swan: Central banking and financial stability in the age of climate change

Climate change poses new challenges to central banks, regulators and supervisors. This book reviews ways of addressing these new risks within central banks’ financial stability mandate. However, 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.

Foreword by Agustín Carstens

A growing body of research by academics, central banks and international institutions including the BIS focuses on climate-related risks. These studies show that physical risks related to climate change can severely damage our economies, for example through the large cost of repairing infrastructure and coping with uninsured losses. There are also transition risks related to potentially disorderly mitigation strategies. Both physical and transition risks, in turn, can increase systemic financial risk. Thus their potential consequences have implications for central banks’ financial stability mandate. All these considerations prompted central banks to create the Central Banks and Supervisors Network for Greening the Financial System (NGFS), which the BIS has been part of since its inception.

This book helps to trace the links between the effects of climate change, or global warming, and the stability of our financial sectors. It includes a comprehensive survey of how climate change has been progressively integrated into macroeconomic models and how these have evolved to better assess financial stability risks stemming from climate change (eg stress testing models using global warming scenarios). But the book also recognises the limitations of our models, which may not be able to accurately predict the economic and financial impact of climate change because of the complexity of the links and the intrinsic non-linearity of the related phenomena. Nevertheless, despite the high level of uncertainty, the best scientific advice today suggests that action to mitigate and adapt to climate change is needed.

Naturally, the first-best solution to address climate change and reduce greenhouse gas emissions is Pigovian carbon taxation. This policy suggests that fundamental responsibility for addressing issues related to climate change lies with governments. But such an ambitious new tax policy requires consensus- building and is difficult to implement. Nor can central banks resolve this complex collective action problem by themselves. An effective response requires raising stakeholders’ awareness and facilitating coordination among them. Central banks’ financial stability mandate can contribute to this and should guide their appropriate involvement. For instance, central banks can coordinate their own actions with a broad set of measures to be implemented by other players (governments, the private sector, civil society and the international community). This is urgent since climate-related risks continue to build, and negative outcomes such as what this book calls “green swan” events could materialise.

Contributing to this coordinating role is not incompatible with central banks doing their share within their current mandates. In this sense there are many practical actions central banks can undertake (and, in some cases, are already undertaking). They include enhanced monitoring of climate-related risks through adequate stress tests; developing new methodologies to improve the assessment of climate- related risks; including environmental, social and governance (ESG) criteria in their pension funds; helping to develop and assess the proper taxonomy to define the carbon footprint of assets more precisely (eg “green” versus “brown” assets); working closely with the financial sector on disclosure of carbon-intensive exposure to assess potential financial stability risks; studying more precisely how prudential regulation could deal with risks to financial stability arising from climate change; and examining the adequate room to invest surplus FX reserves into green bonds.

The BIS has been collaborating with the central bank community on all these aspects. In addition, in September 2019 it launched its green bond BIS Investment Pool Fund, a new vehicle that facilitates central banks’ investements in green bonds. And with this book it hopes to steer the debate and discussions further while recognising that all these actions will require more research and be challenging, but nevertheless essential to preserving long-term financial and price stability in the age of accelerated climate change.

Agustín Carstens

BIS General Manager

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