Economic Letter
Climate Change and the Irish
Financial System
Philip R. Lane
Vol. 2019, No. 1
Climate Change and the Irish Financial
System
Philip R. Lane, Governor of the Central Bank of Ireland
Monsignor Pádraig de Brún Memorial Lecture, NUI Galway 5 February 2019
In this Economic Letter, I describe the challenges posed by climate change
for the Irish financial system. An increase in the frequency of severe weather
events has implications for macroeconomic outcomes, asset prices, house
prices, credit risks and the cost and coverage of insurance contracts. In
addition, the necessary transition to a low-carbon economy (supported by a
phased schedule of increasing carbon taxes) requires considerable
investment by households, firms and the government. If the pace of transition is
too slow, a sharper adjustment will be ultimately required, posing
macroeconomic and financial stability risks. As the macroprudential authority, the
Central Bank will need to ensure that these financial stability risks are
contained by improving the climate resilience of the financial system. As the
prudential and conduct regulator, the Central Bank also has a lead role in
ensuring that financial firms incorporate climate change into strategic and
financial plans, while ensuring that consumers have sufficient information to
navigate the financial risks posed by climate change.
Introduction
Our mission statement reads: "The Central Bank of Ireland serves the public interest by
safeguarding monetary and financial stability and by working to ensure that the financial
system operates in the best interests of consumers and the wider economy." If we are to
fulfill this mission, it is a strategic priority for us to address the challenges posed by climate
change for the financial system.
This holds true for several reasons. First, climate change will be an important influence on
macroeconomic outcomes in the coming decades: both directly through weather shocks
and the shift towards low-carbon technologies, and indirectly through its impact on the
evolving expectations of households and firms about the future trajectory of the economy.i
Second, although this is not the base case, I will argue later in this lecture that financial
stability is threatened if we ignore the systemic risks associated with climate change. Third,
consumers are financially exposed to climate change through a variety of channels. Fourth,
given the environmental risks and structural changes in the wider economy associated with
the transition to a low-carbon economy, our regulatory policies and supervisory practices
must address the financing of the related shifts in the structure of the economy and the
investments required to adapt to climate change.
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These issues cut across all parts of the financial system. In many countries, different
institutions are responsible for the regulation and supervision of individual financial sectors, with
further divisions between prudential and conduct regulatory authorities. Furthermore, the
microprudential supervision of individual firms is often separated from the
macroprudential policy authority that is tasked with the design of systemic policies to safeguard financial
stability.
In contrast, the Central Bank of Ireland has a wide mandate. In addition to our central
banking functions, we are the prudential and conduct regulator for banks, insurance companies,
investment firms, funds and we also regulate the operation of financial markets and the
issuance of securities. Moreover, we are also the national macroprudential authority, the
national resolution authority and operate the deposit guarantee scheme. As such, we are well
placed to take a system-wide and holistic perspective on the implications of climate change
for the financial system. As part of the European System of Financial Supervision, we work
in partnership with the European-level supervisory authorities and the other national
regulators across the EU. In turn, at a global level, the common challenges posed by climate
change also mean that much is taking place at a global level in terms of coordinating the
response of regulatory authorities to these challenges.
Although the primary focus of this lecture is on the macro-financial implications of climate
change, it is useful to start with a brief overview of the wider context. In response to the
2015 Paris Agreement of the United Nations Framework Convention on Climate Change
(UNFCCC), the European Union has committed to a 40 percent reduction in emissions by
2030 (compared to 1990 levels) and the attainment of carbon neutrality by 2050.ii Meeting
these targets is critical as part of the worldwide effort to limit the extent of global warming,
with the reports of the Intergovernmental Panel on Climate Change (IPCC) laying out the
consequences of a sustained increase in global temperatures. Based on Met Eireann data,
the global shift in temperatures is also evident in Ireland: the average temperature during
1991-2016 was substantially above the 1960-1990 average temperature.
At the domestic level, Desmond (2018) provides an assessment of the current state of
national preparedness: this study finds that much of the enabling policy framework has been
put in place but a considerable system-wide effort is required to implement the many changes
needed to build a low-carbon, climate-resilient Ireland. As signalled in the 2018 annual
report of the Climate Change Advisory Council (CCAC), sustained action is required if Ireland
is to meet its national transition objective and comply with international targets, especially
given the current trajectory of rising greenhouse gas emissions.
As part of a comprehensive policy package, carbon taxes will have a central role in guiding
the energy transition by providing the economic incentive to switch from high-carbon to
low- or zero-carbon technologies and products. In Ireland, the CCAC has recommended
a phased increase in the carbon tax from the current e20 per tonne to e80 per tonne by
2030.iii In terms of benchmarking, it is worth noting that some countries already have
carbon taxes at the upper end or even in excess of this range, with the Swedish carbon tax
currently at $139 (e112), Switzerland at $101 (e81), Finland at $77 (e62), Norway at $64
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(e52) and France at $55 (e44) (World Bank 2018).iv
The economy-wide and societal challenges posed by climate change mean that it is inevitable
that the financial system has a central role in managing climate risks and financing the
carbon transition. Accordingly, the strategic plans of financial firms will have to address
climate change. Equally, as the guardian of financial stability and the financial regulators,
central banks have a leadership role in ensuring that climate change is a strategic priority for
the financial system as a whole. Accordingly, having spent the last decade repairing the
financial system after the international banking crisis, the global central banking community
is increasingly turning its attention to the longer-term challenge of improving the climate
resilience of the financial system and the wider economy.
A Macro-Financial Perspective on Climate Change
In assessing the macroeconomic and financial impact of climate change, a dual approach
is required. Along one dimension, climate change is associated with phenomena such as a
greater frequency of more severe weather events and trend factors such as the
implications of global warming for the physical environment facing producers in different regions
and sectors. The increasing frequency of adverse weather events is already evident. For
instance, as noted by Carney (2018), the value (in 2015 prices) of registered weather-related
loss events (both insured and uninsured) has tripled from around $50 billion annually in the
1980s to $150 billion annually over the past decade.
Along another dimension, the policy response to climate change is to induce a carbon
transition in the world economy: over time, a schedule of incremental increases in carbon taxes
(together with other regulatory measures) will induce an all-economy investment effort
to reduce carbon dependence and adopt alternative technologies. As noted by Villeroy de
Galhau (2018), the IPCC estimate is that the world needs to spend $900 billion annually
until 2050 on energy-related mitigation investments if global warming is to be limited to 1.5
degrees. While substantial in absolute terms, this represents less than one percent of 2017
world GDP. At a European level, it is estimated that the required additional annual
investment over 2021-2030 is e180 billion (European Commission 2016, 2018). While there is
an important role for public investment, the bulk of the adjustment will fall on the private
sector.
Given the variation in the impact of weather events and the carbon transition, it is useful
to take a sector-by-sector approach in thinking about the financial implications of climate
risks and the carbon transition. At the same time, a comprehensive analysis also needs to
take into account the interdependencies across sectors and the configuration of indirect
exposures through such inter-linkages. In what follows, we focus on sector-specific
considerations, while recognising the importance of developing fully-integrated assessment
models.
In thinking about the relevant time horizons for the materialisation of climate risks and the
execution of the carbon transition, the multi-stage targets for progress in emissions reduc-
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tion by 2030 and 2050 provide useful near-term and medium-term benchmarks. At the
same time, horizon uncertainty remains a central component of the wider macro-financial
uncertainty associated with climate change.
One basic split is between energy producers and energy consumers.v In recent years, the
energy production sector has already moved some distance along the transition path by
increasing the share of renewables in energy production and announcing the 2025 closure of
the only coal-using electricity plant (Moneypoint), even if the speed of adjustment in
relation to the future of peat as an input has not been finally settled (Climate Change Council
2018). Clearly, much remains to be done in terms of the transformation of the energy
production sector. Still, on a comparative basis, the adjustment challenge facing Ireland in
relation to energy production is less than in some other countries, given the lower dependence
on coal and oil as inputs. In addition, energy suppliers will have to invest in new
infrastructural rollouts, including support for the switch to electric cars.
Turning to the household sector, there are several challenges over the coming years.vi First,
households will have to devote resources to retrofitting homes in order to reduce energy
consumption. While part of the cost may be met by public subsidies, the bulk of this
expenditure will have to be met by individual families. Given the multi-year payoff to such
household capital expenditures, much of this investment will need to be financed through home
renovation loans.
Second, households face the prospect of more expensive and/or more curtailed insurance
policies to the extent that there is an increased frequency of severe weather events. Even
allowing for some mitigation through public investment in improving infrastructural
resilience, more expensive premia or exposure to non-insurable risks mean that home owners
will have to build up rainy-day funds to cover or absorb these risk events. Moreover, house
prices are likely to be more volatile, in response to revisions in assessments of
climaterelated property exposures.
Third, household spending on transportation will be transformed. In part, the balance
between private cars and other types of transport will shift. In part, the adjustment will take
the form of a shift from oil-fuelled to electric-powered cars.vii If this shift takes the form of
a steady annual switching rate, the depreciation rate of the existing stock of oil-fuelled cars
will gradually increase, without any severe shock to the wealth of Irish households or
deterioration in the credit risk embedded in the provision of car financing packages.
In contrast, if the switching rate is too slow, a future cliff edge risk will exist, in which
households scramble to sell oil-fuelled cars, with a collective loss of value affecting owners and
credit providers. For completeness, it is also possible to envisage an excessively-rapid
switching rate that would also generate a valuation shock. However, the feasibility of a sudden
large-scale lurch towards electric cars is limited by capacity limits among car producers to
meet a short-term surge in demand and by the low likelihood of a sharp near-term jump in
the carbon tax rate.
Fourth, households holding direct investment portfolios or indirect portfolios (through de-
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fined contribution pension plans) are exposed to carbon-related shocks to financial asset
values. There are two categories of market risks. First, current market assessments of the
value of carbon-related assets (for example, the assets of oil-producing firms) may turn out
to be incorrect, if the speed or nature of the carbon transition turns out to be more rapid or
more disruptive than current projections. Second, as will be discussed further in the next
section, the carbon transition may be associated with macroeconomic disruption (inducing
a general financial market correction), especially if excessive gradualism ultimately requires
a sharper transition adjustment in the future.
Turning to the corporate sector, firms will also have to devote resources to retrofitting
offices, factories and retail outlets. In addition, the commercial insurance market faces the
same set of issues as the home insurance market. Firms that offer defined-benefit
pension plans will have to address climate-related market risks. Furthermore, the corporate
sector faces its own transportation challenges in terms of the transportation of goods and
business-related travel.
In terms of production processes, firms will also have to reduce reliance on carbon-intensive
technologies. This technological challenge will involve a combination of innovation (finding
novel solutions) and imitation (implementing best practices from around the world). In part,
this transition will take place within existing firms and industries; in part, this transition will
be achieved by new firms and new industries that are unburdened by legacy assets and
technologies. The balance between within-firm adjustment versus the entry of new firms
will be a critical factor in determining the balance between debt and equity in financing the
transition, since startups naturally require more equity finance than incumbent firms.
The construction sector faces particular challenges. In common with other industries, it
will have to adapt in terms of switching towards more environmentally friendly materials
and production techniques. However, the economy-wide requirement to retrofit existing
structures and ensure that new builds meet high energy standards constitutes a structural
shift in the role of the construction sector in the economy. In turn, this calls for a
supportive institutional environment to ensure that there is sufficient availability of construction
workers with the required skills, together with the constellation of policies that will
facilitate scale efficiencies in the rollout of this work programme.
Similarly, the agricultural sector faces both transition challenges and opportunities. In
addition to grappling with the curtailment of greenhouse gas emissions, farmers will have to
respond to possible environmentally-related shifts in consumer preferences. At the same
time, biomass fuels and afforestation are likely to present new opportunities for farmers.
The government faces a range of challenges in relation to the public finances and the
operation of the public sector. The public investment programme will have to devote
sufficient resources to the retrofitting of the public housing stock, schools, hospitals and other
publicly-owned buildings. In addition, public investment will be required for climate
adaptation, including protection against flooding and rising sea levels. In addition, it will also have
to support the energy conversion of the public transport system. While respecting the "pol-
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luter pays" principle, public subsidies and transfers are likely to play an important role in
assisting domestic households and firms in financing the carbon transition and supporting
associated research and development activities.
Furthermore, the global public good nature of the carbon transition and climate justice
motivations will likely see increasing expenditure at European and global levels in finding
common solutions and assisting the most vulnerable regions of the world. Taken together, these
different lines of carbon-related public expenditure constitute a trend factor that must be
integrated into long-term budgetary strategy.
Having outlined the sector-by-sector issues, it is also important to develop an integrated
assessment that takes into account inter-sectoral interdependencies. At one level, this
requires sufficient knowledge of intermediation chains in production in order to
understand the impact of a shift in production or asset values in one sector on production or asset
values in other sectors. At another level, non-trivial climate-related or transition-related
shocks will have an impact at an aggregate level and operate through the standard range
of macroeconomic transmission channels. Accordingly, the assessment of the financial
implications of climate change also needs to include macro-level scenario analysis and stress
testing.
In this section, I have outlined how the carbon transition is likely to affect the economy in
the coming years and decades. In the next section, I turn to the implications for the financial
system and, especially, the challenges facing policymakers, financial regulators and central
bankers.
Challenges for the Financial System and the Macro-Financial Policy
Framework
In this section, I first briefly discuss the implications for monetary policy before next
turning to financial stability analysis. Subsequently, I outline the agenda facing financial
regulators and supervisors.
As emphasised by Carney (2015, 2018), a fundamental challenge in addressing climate
change is the "tragedy of the horizon": the long-term nature of climate change means that it
falls outside the typical short- or medium-term planning horizons of consumers, firms and
(for that matter) policy organisations. Accordingly, it requires concerted effort and
leadership to ensure that sufficient attention is paid to climate-related risks, which have a
different frequency and time distribution compared to other types of macro-financial risks. In
particular, central banks and financial regulators have a special responsibility to drive
momentum in addressing climate change.
In relation to monetary policy, climate change poses several challenges. At one level, an
increase in the frequency and severity of weather shocks raises the volatility of inflation,
sectoral relative price levels and output. At another level, the underlying path for
potential output will shift due to the structural changes associated with climate change and the
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carbon transition. Moreover, the volatility and level of output will also be affected if carbon
policies do not deliver a smooth transition path but rather induce non-linear adjustment
through excessively-accelerated or excessively-delayed policy packages. Each of these
considerations will affect the execution of monetary policy, both in terms of calibration and
operational frameworks.viii In addition, through its asset purchase programme and its
collateral framework, the balance sheet operations of the Eurosystem have a significant impact
on the market for green bonds.
Turning to the risks to financial stability posed by climate change, one category relates to
physical shocks such as a severe weather event or the cumulative deterioration in the
sustainability of a given region as a location for production.ix Another category relates to
various types of transition risks. For instance, if the carbon transition is excessively delayed
by insufficient policy action (including inadequate increases in carbon taxes), a sharp
policy shift will be ultimately required. Such a sudden transition would imply a discrete loss in
the value of installed capital together with an associated drop in asset prices and would be
sufficiently disruptive to trigger a general recession (ESRB 2016, Vermeulen et al 2018).
Other disruptive transition scenarios include an over-ambitious schedule for carbon taxes,
which outpaces the capacity of the economy to switch to low-carbon production
techniques. It is possible to envisage an expectations-driven contraction under which
households and investors revise beliefs about the economic salience of climate change, even in
the absence of immediate policy actions. For instance, a sudden drop in demand for
oilfuelled cars (in advance of sufficient scale in the production of electric cars) could have a
significant impact, especially for economies that are specialised in this sector.
Accordingly, it is now commonly accepted that climate change constitutes a material
financial stability risk. This calls for ongoing monitoring of climate risks, together with the
development of climate-driven scenario analyses and stress tests. By extension, the results of
such analyses may call for the appropriate macroprudential policies to mitigate these risks
(D'Orazio and Popoyan 2018).
The implementation of this agenda is not easy, in view of the data and modelling
requirements to calculate the mapping between physical risks and macro-financial outcomes.x
Vermeulen et al (2018) provide an important example that considers a range of climate
stress tests for the Dutch financial system, corresponding to the various scenarios outlined
above. Importantly, the macroeconomic outcomes that are triggered by the climate risk
scenarios are generated by a multi-country macroeconometric model, since financial firms
are exposed to foreign risks as well as domestic risks.xi In this study, the authors
approximate the carbon exposures in the bond and equity portfolios of Dutch banks, insurance
companies and pension funds (plus the corporate loan books of major banks) by
calculating transition vulnerability indicators for fifty-six industries.xii In addition to these sectoral
exposures, asset values are also affected by the shifts in risk-free interest rates associated
with each scenario.
The results show that Dutch financial institutions would incur significant losses in climate-
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related stress scenarios. In turn, such losses would lead to substantial declines in the capital
and solvency ratios tracked by prudential regulators. Accordingly, this study demonstrates
the salience and feasibility of climate stress testing for the financial planning of the financial
sector and the supervisory strategies of central banks and financial regulators.
Turning to the regulation and supervision of firms and markets, climate change poses
several challenges. Financial firms (banks, insurance companies, pension funds and investment
funds) have to work out the market risks and credit risks associated with climate change.xiii
Even under a smooth adjustment path, the considerable structural changes associated
with the carbon transition mean that historical correlation patterns will not provide a
reliable guide to the future distributions of return; this point holds even more forcefully in the
stress scenarios just discussed.
This uncertainty feeds into re-assessments of optimal allocation and risk management
strategies in the design of equity/bond portfolios and loan books. Insurance companies face
an additional challenge in modelling the implications for their liabilities (the risks they
insure). It is essential that the financial industry does a good job in taking on this challenge if
the switch to sustainable forms of economic activity is to be facilitated and the risks to the
household sector (the ultimate owner of financial assets) are to be minimised. In terms of
supervisory strategies, regulators will need to conduct environmental/climate risk
assessments in order to evaluate whether firms are meeting the expected level or risk
management. Furthermore, consumers and investors require that conduct regulators ensure that
climate-related risks are properly disclosed to savers and investors that need to choose
among different investment plans.
For regulators and supervisors, several steps are required. First, clear expectations need
to be laid out for regulated firms. For instance, the Prudential Regulatory Authority in the
United Kingdom has published a draft supervisory statement that sets out expectations
for banks, insurers and investments firms in relation to managing the financial risks from
climate change.xiv There are four dimensions to this guidance: (i) governance; (ii) risk
management; (iii) scenario analysis; and (iv) disclosure. Jointly with the Financial Conduct
Authority (FCA), it is also establishing a Climate Financial Risk Forum to support best practice
in the management of climate-related risks by regulated firms.
Second, sufficient information is required if climate risks are to be adequately assessed.
As reflected in the discussion of climate stress testing above, it is not easy to work out
climate risks at the macroeconomic or industry level: the degree of difficulty at the firm level
is even more severe, given the variation across firms within an industry and the complexity
of supply chains. Accordingly, as highlighted by the work of the Financial Stability Board's
Task Force on Climate-Related Financial Disclosures (TCFD), climate risk assessment
requires each firm (above a scale threshold) to calculate and disclose its carbon exposures, on
the basis of its private corporate information concerning both its current profile and future
plans. In turn, at the portfolio level, ultimate savers and investors must rely on the
information disclosed by intermediaries in relation to the environmental, social and governance
(ESG) characteristics of the underlying securities.
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For such disclosures to be useful, some degree of standardisation is required in order to
ensure comparability. Furthermore, a common taxonomy is essential for a shared
understanding of the information disclosed and the definitions of sustainable financial products
(such as green bonds).xv Going beyond individual securities, a common approach to the
development of benchmark indices is also necessary, in view of the importance of benchmarks
in asset allocation. Accordingly, the first wave of legislative proposals arising from the
European Commission's action plan for sustainable finance tackles these three tasks: developing
regulations for a common taxonomy; disclosure; and benchmarking (European Commission
2018). While the initial focus of the disclosure regulation is on the responsibilities of
institutional investors and asset managers to their customers in terms of factors in their risk
processes, the broader action plan also extends to ESG transparency requirements on
companies. An open question is whether the development of a common taxonomy and
disclosure requirements will subsequently prove useful to regulators in discriminating between
"green" and "brown" credit risks in a systematic manner.
The Network for Greening the Financial System (NGFS) was launched at the Paris One
Planet Summit in December 2017 and provides a platform for central banks and
supervisory authorities to share knowledge and develop common strategies. At the technical level,
its current agenda consists of: (a) a macrofinancial workstream that is sizing the
macroeconomic and systemic risks associated with climate change; (b) a supervisory/microprudential
workstream that is reviewing disclosure practices and environmental-related credit risks;
and (c) a workstream on scaling up green finance that is exploring how central banks and
supervisors should incorporate ESG factors in their operational and monitoring activities in
support of the switch to green finance.xvi Through such initiatives, the global community of
central banks and financial regulators is undergoing its own transition, with climate change
much higher on the agenda compared to a few years ago.
Climate Change and the Central Bank of Ireland
As the central bank, we plan to incorporate the carbon transition into our macroeconomic
and financial stability assessments. Over time, the carbon transition will be an influential
factor in shaping macroeconomic outcomes. Similarly, as discussed in the previous section,
the carbon transition can give rise to financial stability risks. This holds true at both
international and domestic levels, such that our financial stability assessments and
macroprudential policy frameworks will have to be extended to incorporate carbon-related systemic risk
factors.
Our macroeconomic and financial stability assessments rely on a mix of modelling tools
and analysis of the empirical evidence. In order to address climate change, this will require
adaptation of our models to incorporate the impact of both short-term weather events and
long-term climate change. As surveyed by Dell et al (2014) and Batten (2018), there is an
emerging research literature on these challenges but there remains many open questions,
together with the necessary refinements to implement these adaptations in the specific
context of the Irish economy.
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As the financial regulator, we have extensive responsibilities in guiding the adaptation of
the financial system. In terms of reforms to EU financial legislation, the Central Bank
offers technical support to the Department of Finance in its participation in the European
Council and in transposing EU directives into domestic law. Within the framework laid out
in primary legislation, we will participate in the design of regulatory rules and supervisory
frameworks at European and global levels and roll out the domestic implementation of new
policies and initiatives. More generally, given the common nature of the challenges, we will
collaborate and coordinate with the international community of central banks and financial
regulatory authorities in implementing our climate change work programme.
Since our regulatory mandate is broad, this work will span a range of areas. It will include
the revisions to the regulation of financial markets, investment firms and the asset
management industry, in addition to the assessment of climate-related prudential risks facing
the banking and insurance sectors. Furthermore, there will be a parallel challenge for our
consumer protection role, given the implications for financial products such as mortgages,
insurance policies and investment funds.
An added dimension to the challenge we face is that we have a dual responsibility. In
addition to assessing domestic climate-related risks and understanding the national carbon
transition path, we are also the regulator of many externally-orientated firms that conduct
business on a pan-European basis and have a global customer base. Accordingly, the broad
geographical scope of the financial firms that we regulate mean that we will have to factor
the considerable country variation in climate risks into our supervisory strategies.
In managing our investment portfolio, ESG criteria are taken into account.xvii In particular,
the equities component of our investment portfolio is managed in line with ESG criteria:
compliance with the UN-supported Principles for Responsible Investment (PRI) was a
condition in allocating the mandate for this portfolio.xviii In relation to the bond component of
our investment portfolio, an ESG policy for this asset class is currently in preparation.
Already, the Bank holds ten green bonds (e221 million) in our investment portfolio and six
green bonds (e193 million) as part of the public sector purchase programme component of
the ECB's quantitative easing measures.xix
In terms of our own carbon footprint, the construction of our new headquarters on North
Wall Quay provided an opportunity to design a building that was energy efficient, had low
operating costs with a healthy and ambient indoor environment for the occupants.xx
Underlining this commitment, the Bank has signed up to the Business in the Community Ireland
Low Carbon Pledge that targets a 50 percent reduction in (scope 1 & 2) greenhouse gas
emissions by 2030.
In terms of energy consumption, a challenge for the intern