Marja Nykänen: Problems in embedding climate risks into the
traditional financial risk framework
Speech by Ms Marja Nykänen, Deputy Governor of the Bank of Finland, at the Bank of Finland
and the Finnish Ministry of Finance conference "Greener Finance for Sustainable Future",
Helsinki, 31 October 2019.
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Ladies and Gentlemen,
Welcome to the second day of the conference. I am glad to see such a broad spectrum of
expertise here. I am Marja Nykänen, Deputy Governor of the Bank of Finland.
In recent years, the Bank of Finland has become active in climate-related issues. For example,
we participate in the work of the Network for Greening the Financial System's work streams and
plenary.
The Intergovernmental Panel on Climate Change (IPCC) publishes reports on scenarios that will
happen if we fail to lower our emissions. From the most recent special report, we learned that
the Arctic and polar areas will experience considerable transformations as glaciers melt at an
increasingly faster rate. The melting creates a massive amount of meltwater, which will have
significant impact on rising sea levels. But the report shows that polar areas also face other
consequences. Let's take, for example, the Arctic Ocean.
It provides a habitat for many species. By 2100, it will freeze later in the year with thinner ice and
leave those species without a sufficient habitat. Also by 2100, up to 80% of Scandinavian and
Central European mountain glaciers might have vanished.
For me, such future prospects are unsettling.
Even though the scenarios seem worrying, it is not too late to act. We, as finance professionals,
play an important role in this fight against climate change.
As we heard yesterday, a significant amount of investment is required to transform our
economies into sustainable ones. To facilitate investment, we need a well-functioning financial
market with availability of green funding instruments. And, in order to ensure a well-functioning
financial system, we must keep an eye on the system-level climate risks that might threaten the
stable functioning of the financial system and smooth flows of funding for sustainable
investments.
In the discussion of climate change risks to the financial sector, two types of systemic risks have
been identified. Firstly, there are physical risks, namely damage caused by extreme weather
events or climate-related natural disasters. These include hurricanes, floods, storms, heat
waves etc. In addition to potential risks to life, such events generate great financial damage.
For example, such events may damage properties. If the property is insured, insurance
companies will carry the loss. If the property is not insured, the owner of the property will have to
pay for the damage. In the event that the property owner becomes insolvent or the collateral
value of that property is lowered, credit institutions may also be at risk.
The extent of physical risks is difficult to estimate in advance, but in extreme cases the potential
losses may be significant. In addition, as the risk horizon is long, the frequency and severity of
extreme weather events will change over decades. This makes it even harder to model physical
risks in the traditional financial risk framework.
The second recognised risk type is transition risk. Transition risk arises when carbon-intensive
companies need to adjust their business models to become less carbon-intensive. The
adjustments may be a consequence of changes in climate policy or consumer preferences, but
they may result in rapid changes in company valuations. And, in extreme instances, in the
valuations of entire industries. For companies that confront transition risk, the adjustment
requires investments and the replacement of old technologies and production capacity. The big
question is whether this transformation can be done smoothly or whether it becomes extremely
costly and burdensome.
Transition risk may then manifest itself in investor portfolios, where such revaluations may force
investors to book losses. Transition risk is an outcome of a complex process, which makes it
even harder to estimate. Comparing physical and transition risks, it makes me wonder whether
the actual climate or the climate policy is more difficult to predict. The more we delay effective
climate policies, however, the quicker and the more powerful the policies will need to be in the
future.
Every financial institution needs to assess these climate-based risks and incorporate them into
their risk management frameworks.
A related question is how financial supervisors and regulators should approach climate-based
financial risks. What should we expect from financial institutions and how can we help them
figure out what to do?
Firstly, it is important to identify best practices and to share experiences between supervisors
and within the whole financial industry. The Network for Greening the Financial System (NGFS)
offers a platform for considering the best practices to fight climate change in the financial sector.
The network is global and it was founded in December 2017. Nowadays, the NGFS has 46
members and 9 observers. The observers include, for example, the IMF, the World Bank and the
OECD.
Last April, the network published its first comprehensive report: A Call for Action. The report
contains four recommendations for central banks and supervisors and two additional
recommendations for policymakers to facilitate the work of central banks and supervisors.
The recommendations for central banks and supervisors steer, for example, the assessment of
climate-related financial risks in the financial system and the bridging of data gaps. The
recommendations also encourage central bankers to lead by example in their own operations by
integrating sustainability factors into own portfolio management.
After publishing the recommendations, the work of NGFS has continued to be active. The
NGFS's work is divided into three different work streams, which are: Micro-prudential and
supervision, Macro-financial, and Mainstreaming green finance. The work streams build
analytical capacity within the member organisations and publish handbooks on best practices
based on wide consultations of NGFS members and other relevant institutions.
Just a couple of weeks ago, in October 2019, the network published a report titled A Sustainable
and Responsible Investment Guide for Central Banks' Portfolio Management. In this report, the
NGFS provides further guidelines concerning the earlier published recommendation on
integrating sustainability factors into own portfolio management and encourages central bankers
to adopt Sustainable and Responsible Investment (SRI) practices into their own portfolio
management.
The major challenges in analysing risks and designing optimal policies are the lack of
comprehensive and comparable data as well as the, as yet, inadequate modelling methods.
While we already have a high volume of climate-related data, it has significant limitations. One of
the main concerns is that climate-based risks are hard to identify from the historical data, as the
impact of climate change may not yet show up in the data.
Though there might be a large number of data providers, there are many challenges associated
with the data. Firstly, the data are expensive and data from different providers are not
comparable. Secondly, company-level data vary due to different disclosure methods. Thirdly, the
extent to which a business model is dependent on carbon-intensive suppliers hardly shows up in
company-level reporting. Furthermore, it is difficult to relate the climate data to the financial data
of the companies.
The lack of adequate data and models cannot be a reason to do nothing, however. It is each
financial company's own responsibility to develop their risk assessment methods. Collaboration
and common understanding are needed to ensure that the analysis is fit and relevant for the
purpose.
Once we identify the best practices for risk assessment, we can then talk about which tools can
be used to incentivise sustainable investing. Green Supporting Factors (GSF) and Brown
Penalising Factors (BPF) have often been under discussion. In my opinion, unless we have a
very good basis from a financial risk point of view for risk differentials between green and brown
investments, we should not introduce changes to prudential rules just for the sake of incentivising
certain types of investments.
But if we need to choose between these two, then it should rather be the Brown Penalising
Factors than the Green Supporting Factors. The basis for this is that climate change and climate
policies do not show up in past data and therefore the risks stemming from them are not
necessarily reflected properly in the risk calculations.
Instead of supporting or penalising certain types of investments, supervisory expectations would
be a convenient way of guidance. Some supervisors, the Bank of England for example, have set
out supervisory expectations for financial institutions on how they should manage climate risks.
The supervisory expectations of the Bank of England cover governance frameworks, risk
management, the use of scenario analysis and appropriate disclosure.
In my opinion, risk management is the key element. To practise proper risk management, we
need to figure out the best frameworks to identify and evaluate risks. We should also use some
level of standardisation in the risk management framework for climate-based risks so that the
outcomes are comparable between institutions. Adequate reporting and disclosure are also
relevant. To achieve proper risk management, collaboration and discussion between institutions
becomes important.
Everyone knows that climate-based financial risks are challenging and difficult to approach, as
we haven't yet established a common framework. I hope we can lay a few building blocks for this
framework today. I am very much looking forward to the panel on financial stability and the risks
from climate change this afternoon.
I believe that by discussing and sharing experiences, we will be able to find the best approach to
this challenging issue of fighting climate change without compromising financial stability. We just
need to find the best practices and at the same time execute wise financial regulation to support
the greening of the financial system.
Now, let's enjoy the second day of the conference; we have a very interesting keynote and two
panels yet to come.
Thank you!