Egil Matsen: Climate change, climate risks and Norges Bank
Speech by Mr Egil Matsen, Deputy Governor of Norges Bank (Central Bank of Norway), at
Norges Bank, Oslo, 8 November 2019.
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Accompanying charts of the speech.
Introduction
This autumn, news reports have included a hurricane in the Bahamas, a typhoon in Japan and
large-scale wildfires in California. Many lives have been lost, and the economic losses have been
substantial.
While we should be cautious in attributing single weather events to global warming, climate
research points towards an increase in extreme weather events and natural disasters in the
years ahead. What we have seen so far may be a forewarning of what is to come.
Chart: The temperature is rising
Global warming is one of the greatest challenges of our time. The global average temperature
has increased by about 1 degree Celsius above pre-industrial levels. It is widely accepted that
climate change is largely human-induced. Greenhouse gas emissions must be drastically
reduced if the temperature goals of the Paris Agreement are to be reached.
Putting the necessary measures in place has proved to be demanding. From an economist's
standpoint, a carbon tax would be the most effective way to reduce greenhouse gas emissions -
the polluter must pay. However, carbon taxes and other measures are often met with opposition.
Costs are imposed locally, while the gains from lower emissions are enjoyed by all. The
temptation is to be a free-rider. In addition, the consequences of current emissions will largely be
borne by future generations. Is this perhaps why there is less incentive to implement measures
today?
To mitigate greenhouse gas emissions, the most important measure is the work conducted in
the political arena, together with the development of more environment-relatedly friendly
technologies. At the same time, the authorities, private individuals and companies must address
a new type of economic risk, climate risk. Climate risk includes physical climate risk and
transition risk.
Physical climate risk is associated with uncertainty about the economic consequences of higher
temperatures and more extreme weather. There is a not insignificant probability of an outcome
that is far more severe than the Paris Agreement is aiming for. Even if such an outcome does
not materialise, and even if mitigation measures are able to limit the extent of the damage, the
economic consequences could be considerable. Poor countries in the Global South will likely be
hardest hit.
Chart: Insurance payouts after natural disasters
Norway is in a less vulnerable position, but we see that the weather is changing too. River and
coastal flooding has increased and the damage caused is more severe, as reflected in insurance
claims payouts. Over the past ten years, annual insurance payouts for climate-related flood and
storm damage have been on average about five times higher than in the 1980s.
Transition risk is associated with the economic consequences of the transition to a low-carbon
economy. Climate policy measures, changes in public attitudes and the emergence of more
environment-relatedly friendly technology will have an impact on both production methods and
consumption patterns. This will create both opportunities and challenges for the business sector.
Not all companies will make the transition to a low-carbon economy. Others will benefit from the
restructuring involved, and new companies and industries may emerge.
It is uncertain which climate policy measures will be introduced ahead, particularly internationally.
If little is done in the short term, economic decisions today must take into account that climate
policy may be abruptly tightened later. Postponing climate mitigation measures will also increase
the risk of severe and irreversible climate change in the future.
Responsibility for achieving the Paris Agreement's goals lies with the political authorities.
However, we already know that climate change and adjustments to a low-carbon economy will
affect large parts of the economy. Norges Bank is responsible for maintaining price stability and
the stability of the financial system. In its conduct of monetary policy, the Bank also promotes
high and stable employment and output. The Bank is also tasked with managing the Government
Pension Fund Global (GPFG) and is thereby a major investor in global capital markets.
A feature common to these tasks is the identification and management of uncertainty and risk.
Climate-related economic and financial risks have important implications for all of Norges Bank's
operations. Climate change and climate risk must also be taken into account by central banks.
In order to work on these issues, central banks and financial supervisory authorities have formed
the Central Banks and Supervisors Network for Greening the Financial System (NGFS). Norway
is represented by Norges Bank and Finanstilsynet (Financial Supervisory Authority of Norway).
The aims of the network include building knowledge and sharing best practices on climate risk
management within the financial system.
Climate change, the macroeconomy and monetary policy
Natural disasters and extreme weather have an adverse impact on the production of goods and
services. The agricultural sector is particularly vulnerable. But extreme weather events have also
disrupted infrastructure and production chains. In the years ahead, climate change will lead to an
increase in the frequency and intensity of weather events that have a negative impact on output.
In Norway, monetary policy is the first line of defence against economic shocks. When Norges
Bank sets the policy rate, most weight is usually given to the outlook for the Norwegian economy
over the next few years. Thus, there could be implications for monetary policy if extreme weather
events occur that affect inflation and output prospects within this horizon.
Economists refer to events that unexpectedly reduce output as negative supply shocks. Such
shocks typically push up the price of the affected goods. There are many examples worldwide of
spikes in food prices following extreme weather events or long periods of drought. Electricity
prices vary considerably in Norway depending on the amount of precipitation. For example, the
combination of a cold winter and a dry summer contributed to a 26 percent rise in electricity
prices, as measured by the consumer price index, in 2018.
Negative supply shocks thus lead to lower output but higher inflation. This poses a dilemma for
monetary policy. Should the policy rate be raised to curb inflation? Or should it be lowered to
stimulate the economy?
Chart: Quarterly growth Norway, autumn 2018
With our flexible inflation targeting regime, we will not usually change the policy rate if a supply
shock is transient. One example is the decline in agricultural production in Norway in 2018 as a
result of an unusually hot and dry summer. Production fell by 40 percent in the third quarter. Even
though Norway's agricultural sector is small, the fall in production led to a decline in economic
growth between the second and third quarter. We assessed the decline as transient, and the
policy rate was not changed. However, if such an event leads to a persistent rise in inflation in the
next round, this may affect the policy rate.
So far, more unstable weather has only had short-term effects on output, employment and
inflation in Norway and other advanced economies. Wide fluctuations have been observed in
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food and energy prices in particular , but there have up to now been few instances of physical
climate change influencing macroeconomic developments in these countries.
Chart: Prices for European CO2 emission allowances
Climate policy measures, such as higher carbon taxes, will also affect price and demand
developments. Prices for European CO2 emission allowances have increased by close to 500
percent over the past two years. This has pulled up coal and gas prices in Europe and has also
contributed to higher electricity prices in Norway.
Even though the impact of climate change on aggregated economic variables will not necessarily
be substantial in the next few years, the situation for individual businesses might be different.
Norwegian firms will have to be prepared for the introduction of new climate mitigation measures
and new, more environmentally friendly technology. Public attitudes and consumer demand
patterns are also changing.
Many of Norges Bank's Regional Network contacts report that they are being affected by the
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increased focus on climate and sustainability. Statutory emission limits and customer demands
are steering investment and production methods in a greener direction. A number of retail trade
contacts reported that sales are declining because customers are increasingly focused on
sustainability. The trend towards lower meat consumption has, on the other hand, given a boost
to aquaculture and fish farming.
Chart: Carbon pricing in Norway
A number of industries are likely to have to comply with a stricter climate policy, particularly
industries with low or zero carbon prices today. Stricter climate policy requirements may also
speed up the introduction of new technologies. Some firms will have to undergo major changes,
while others may gain competitive advantages. Electricity production in Norway is largely
environmentally friendly and could be more so. The transition to a low-carbon economy may
therefore provide opportunities for the Norwegian business sector.
On the other hand, our large oil and gas sector may expose the Norwegian economy to transition
risk. This was an issue that then Governor of Norges Bank Hermod Skånland addressed as early
as in 1989: "Many accounts could be given of how they [international climate agreements] will
affect prices and quantities in our production of oil and gas," said Skånland, and he went on: "but
we cannot pretend that they will not be influenced by a climate policy we are pursuing ourselves.
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At the very least, they will increase uncertainty, and in sum, I believe, in a negative direction".
Today, 30 years later, much of Norway's oil wealth has been converted into financial wealth.
Petroleum revenues have been transferred to the Government Pension Fund Global (GPFG)
since 1996. Petroleum revenue spending over the central government budget has been in line
with the so-called fiscal rule since 2001.
Chart: From oil in the ground to financial wealth
The dark blue bars in this chart are the present value of government petroleum revenues at
different dates, while the light blue bars show the value of the GPFG.
The Norwegian government has used this model to convert North Sea oil and gas wealth into a
fund with an investment portfolio diversified across equities, bonds and real estate around the
world. The overall risk, including climate risk, has been reduced.
The Norwegian economy is also exposed to abrupt changes in operating parameters for oil and
gas production through spillovers from offshore activities to the wider economy. We have long
known that Norway's offshore petroleum activities would be gradually reduced. If global climate
policy proves to be stricter than currently expected, the decline in offshore activity may occur
sooner and more rapidly than previously assumed. This will have consequences for Norway's
industry structure.
Even though it is likely that the biggest changes in oil-related industries lie some years ahead,
climate risk may also have an effect on the oil sector in the short term. There are perhaps signs
of this effect in recent years' oil stock prices.
Chart: Valuation of oil stocks
The price-to-book (P/B) ratio is lower for international oil companies than the average P/B ratio in
the stock market, and this gap has widened in recent years. There may be several reasons for
this, but we know that investors' climate risk awareness has increased in the same period.
Measures to influence industry structure are not within Norges Bank's remit. However, if the
decline in the oil-related sector were to occur abruptly, the spillovers to the wider economy could
be considerable. Monetary policy is adjusted to changes in output, employment and inflation and
can therefore support overall activity and employment in a period of restructuring. The
responsibility for the restructuring itself lies elsewhere, not least with the business sector.
The Norwegian banking sector and climate risks
Norges Bank promotes stability in the Norwegian financial system. We have recently published
our annual financial stability report. The report includes an analysis of adaptation to climate risk in
the financial system.
Economic losses resulting from changes in the regulation of greenhouse gas emissions, new
climate-friendly technology or new consumption patterns must primarily be borne by the
individual firm and its owners. In the event of very substantial losses, the firm's lenders will also
be affected. In Norway, these lenders are largely banks. Climate risks, and transition risk in
particular, may thus be a source of credit risk for banks.
Norwegian banks' exposures reflect the Norwegian economy and industry structure. I have
already touched upon the substantial importance of the oil and gas industry to Norway's
economy. Lending to this industry is a possible source of transition risk for banks.
Chart: Oil-related exposures, DNB
Although Norwegian banks have reduced their exposure to the oil industry in recent years, this
industry remains important for banks. However, banks' losses may not be substantial unless a
structural decline in oil-related industries results in substantial spillovers to the wider economy.
This applies not least if there is a sharp fall in prices in the commercial and residential property
markets, where banks' lending exposures are highest.
Banks can make a number of adjustments to reduce their own climate risk, primarily by correctly
pricing the risk associated with their own exposures. Risk premiums on projects that do not meet
green standards should reflect the higher risk associated with these projects. Similarly,
discounts should not be given for so-called green projects unless there are financial reasons for
doing so. A green investment does not necessarily involve lower financial risk.
In order to identify and adapt to their own climate risk, banks depend on relevant disclosure by
the companies in their lending portfolios. Accurately pricing risk is difficult without information
about the level of the borrower's exposure.
For banks, transition risk is also a source of financing risk. There is growing interest in climate
risk among financial investors, including those providing credit to banks. The perception that
some banks are particularly exposed to transition risk may have implications for banks' funding
costs and access to funding.
Thus, just as banks should identify climate risk in their own lending portfolios, they must be
prepared for their own investors to demand improved disclosure of climate-related financial risk.
The recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) are in
the process of becoming normative.
Banks play a vital role in the intermediation of credit to households and businesses. Problems in
the banking sector can quickly have negative consequences for the wider economy. Large credit
losses or difficulties obtaining funding can have ripple effects in the form of lower lending to
households and businesses. Transition risk may therefore contribute to systemic risk.
Central banks and financial supervisory authorities can, within their mandates, promote financial
stability by ensuring that financial institutions include climate risks in their risk assessments.
Climate risks must be addressed in the same manner as other risks facing the financial sector.
To the extent climate risks lead to higher credit risk, funding risk and systemic risk, climate risks
should be included in the assessment of whether banks are sufficiently capitalised and have
adequate long-term funding.
Climate risks and the Government Pension Fund Global
Norges Bank manages the GPFG under a mandate from the Ministry of Finance. The capital is
invested with the objective of achieving the highest possible return within the limits of acceptable
risk. The GPFG's mandate requires responsible investment activities to be integrated into
investment management.
The aim of being a responsible investor is in part to support the long-term financial performance
of the GPFG's investments. In addition, we seek to mitigate the financial risks associated with
environment-related and social conditions in investee companies.
Chart: Invested in more than 9 000 companies in 73 countries
Seventy percent of the GPFG is invested in equities. With ownership shares in more than 9 000
companies in 73 countries, we take part in global growth and value creation. Many of the
companies in the GPFG's portfolio could be impacted by physical climate change and the
consequences of regulatory and technological countermeasures. Climate change could thus
influence the GPFG's long-term return. Against this background, Norges Bank defined company
behaviour towards the authorities regarding environmental and climate issues as a focus area for
active ownership as early as in 2006.
In recent years, interest in responsible investment, and not least climate risk management, has
increased among investors. Investor activity can be divided into two main categories: working
with the companies in the investment portfolio or changing the composition of the portfolio.
The GPFG does both. We draw up expectations for portfolio companies, engage them in
dialogue and exercise our voting rights. The composition of our investment portfolio also differs
somewhat from the broad market index. The Bank's responsible investment work is
concentrated on three pillars.
The first pillar, which we like to refer to as "setting standards", consists of our support for
common international standards and the published expectations drawn up for all the companies
in the portfolio. The Bank's expectations with regard to companies' climate change-related work
were first published in 2009.
If we and other investors are to understand our own exposure to climate risk, we will need
adequate company reporting. To quote Bank of England Governor Mark Carney: "In order to
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watch we must be able to see". To ensure consistency across markets, disclosures should
comply with a common international standard. This would also contribute to raising the bar for all
companies. I have already mentioned the TCFD recommendations. The GPFG supports this
work.
The second pillar of the GPFG's responsible investment management is exercising ownership.
We exercise our voting rights at companies' annual general meetings, and we engage in
dialogue with a large number of portfolio companies. Recurrent topics in our dialogue with banks
include financing palm oil producers and following up TCFD recommendations. Topics related to
climate change have also been an important part of the dialogue with companies that buy and
sell meat in Brazil.
The third pillar is related to the composition of the GPFG's investment portfolio. Our management
mandate requires parts of the fund to be invested in environment-related mandates. The
environment-related mandates were first introduced in 2011. The purpose of the investments
does not differ from that of the rest of the GPFG. The environment-related mandates are required
to contribute to diversification and to improving the return on the GPFG.
Chart: Environment-related mandates
The Ministry of Finance is in the process of adjusting the guidelines for these mandates.
Investments are to be focused on climate-friendly energy, improving energy efficiency, carbon
capture and storage, water technology and the management of waste and pollution. The upper
limit for the environment-related mandates will be increased from NOK 60 billion to NOK 120
billion, as the mandates will be expanded in 2020 to include unlisted renewable energy
infrastructure investments.
Primarily, these will be investments in wind and solar power production. In the Bank's strategy for
the management of the GPFG in the period to 2022, our target is an allocation of around one
percent of the GPFG towards the end of the three-year period. At the GPFG's current value, this
is equivalent to NOK 100 billion.
Renewable energy infrastructure investments will reduce equity and bond investments by an
equivalent amount. Therefore, the risk-adjusted return on the infrastructure investments should
be at least as high as the return on the securities that we could otherwise have had.
Our managers have assessed the risk associated with governance and sustainability in some
companies as so high that we have divested. Most often, these have been companies with
business models that are not sustainable in the long term. This group also includes companies
that emit particularly large amounts of greenhouse gases or engage in activities that contribute to
deforestation.
In addition to such risk-based divestments, we sometimes exclude companies on the basis of
ethical guidelines. These guidelines are set by the Ministry of Finance and serve as the basis for
the Council on Ethics' advice and our decisions on exclusions. Ethical exclusions are not based
on financial risk considerations, but on whether a company's operations or behaviour is in
violation of fundamental ethical norms.
Two of the criteria for exclusion are related to greenhouse gas emissions. One of the criteria
applies to mining companies or power producers with substantial emissions from coal, in either
absolute terms or as a relative share of their operations. In all, 82 companies have been
excluded from the GPFG's investment universe based on the coal criterion. The second criterion
states that companies that through their acts or omissions are responsible for unacceptable
greenhouse gas emissions can be excluded.
This conduct-based climate criterion has yet to result in any exclusions. One of the issues that
has proved demanding is whether a basic norm for ethically acceptable emissions can be
defined. Another issue has been whether it is unethical to emit considerably more than the
industry average if the emissions are part of an emission trading system. The Ministry of Finance
provided important clarification of the application of the climate criterion in this year's annual
white paper on the GPFG. The clarification provides a solid basis for moving forward on the
criterion.
Conclusion
The impact of climate change is already substantial. In 2018, extreme weather events affected
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about 60 million people. At the same time, the number of fatalities after severe storms and
flooding has decreased in recent years. This is partly due to better disaster risk management.
Chart: Lower Manhattan, 30 October 2012
The picture shows a Lower Manhattan in darkness after Hurricane Sandy made landfall in
October 2012. One building obviously had a backup power system when the power supply failed
- the headquarters of the investment bank Goldman Sachs.
Let us take this as a reminder that contingency solutions must also be put in place for the
economy, and not just to deal with power cuts. Extreme weather, policy measures and
technological innovations have financial consequences for households, businesses and
investors. This can have implications for the macroeconomy and for financial markets. As a
central bank, we must adapt to the economic effects of climate change.
In Norges Bank, climate risk has long been on the agenda in the management of the GPFG. For
the rest of the Bank, this field of work is a more recent addition. There is still a great deal we do
not know about the economic and financial consequences of climate change. That is why we are
working with other central banks to build up expertise in this field. Our aim is to play a role in
strengthening the resilience of the Norwegian economy to the challenges posed by climate
change and climate risk.
Thank you for your attention.
1
Parker, M. (2018): "The Impact of Disasters on Inflation". Economics of Disasters and Climate Change, Volume
2, Issue 1, April, pp. 21-48.
2
Regional Network 3/2019. Norges Bank.
3
Skånland, H. (1989): "Refleksjoner ved utgangen av 1980-årene" [Reflections at the end of the 1980s]. Speech
on 23 August 1989. Norges Bank.
4
Carney, M. (2019): "Remarks given during the UN Secretary General's Climate Action Summit 2019". Speech on
23 September 2019. Bank of England.
5
United Nations Office for Disaster Risk Reduction and Centre for Research on the Epidemiology of Disasters
(CRED) (2019): "2018: Extreme weather events affected 60 million people". Press release, 24 January 2019.