Sustainable development and climate risks: the role of central banks
Speech by Ignazio Visco
Governor of the Bank of Italy
Sustainable Development Festival 2019
'Finance and financial system for sustainable development'
The Italian Alliance for Sustainable Development
Rome, 21 May 2019
The question of whether natural resources and the development objectives of
nations are compatible is an issue that has long been debated in the field of economics.
It dates back to at least the end of the 18th century with the works of Thomas Malthus on
food supply and population growth and has re-emerged a number of times since then
in the public debate.
For example, at the start of the 1970s, in the wake of the demographic explosion and
the related exponential growth in consumption, the simulations produced for the project
of the Club of Rome on the 'Predicament of Mankind' set off an alarm which resonated
strongly at international level concerning the risks to the survival of our ecosystems and of
the human race itself. It was then observed that the scarcity of natural resources envisioned
in that analysis, largely based on a linear extrapolation of the trend under way, did not
take sufficient account of two fundamental mechanisms that regulate the functioning of
the economic system: the rebalancing capacity of prices and the endogenous nature of
technological change. When the resources used in the production of goods and services
become more scarce, an increase in their prices discourages demand and provides an
incentive to invest in new production methods that utilize fewer of those resources.
Although these mechanisms make it particularly difficult to make reliable long-term
projections, the fears for 'sustainability' - that is, the ability to meet current needs without
compromising future generations' chances of doing the same - have not faded.
Over the last three decades the biggest concerns have been in relation to the
effects of climate change, a factor for which there are no 'natural' market prices. In 1992,
following the Earth Summit in Rio de Janeiro, the United Nations Framework Convention
on Climate Change was born, giving rise to the Kyoto Protocol (in 1997) and the Paris
Agreement (in 2015). In the autumn of that year, Robert Solow, winner of the Nobel Prize
for Economics in 1997 for his contributions to modern theories of economic growth,
spoke before an audience of environmentalists, stating that:
I do not have to remind you that 'sustainability' has become a hot topic in
the last few years [...] As far as I can tell, however, discussion of sustainability
has been mainly an occasion for the expression of emotions and attitudes.
There has been very little analysis of sustainable paths for a modern industrial
economy, so that we have little idea of what would be required in the way of
policy and what sorts of outcomes could be expected.
Solow feared that the concept of sustainability would remain a slogan, without
materializing into policies to encourage the use of sustainable resources. Almost 30 years
later, data on the trend in greenhouse gas concentration - the leading cause of global
warming - are not encouraging. In fact, the growing use of fossil fuels has pushed the
concentration of greenhouse gases to levels that are dangerously close to generating a
temperature increase of more than 1.5°C, with potentially catastrophic consequences for
our planet according to the United Nations Intergovernmental Panel on Climate Change.
Some effects are already evident. At global level, the last four years have been the
warmest since 1880. In Italy, 2018 was the warmest year in the past two centuries and
2017 was already characterized by a strong intensification in weather conditions, with
severe cases of drought over most of the country that caused serious repercussions on
the water supply.
Climate change and the risks to the financial sector
In Europe, southern countries like Italy will be most affected by the expected
consequences of climate change, which pose new risks for the real economy and for the
stability of the financial sector.
First, there is the 'physical risk' stemming from progressive climate change, in
particular involving an increase in temperatures, greater irregularity in rainfall patterns
and an increased probability of extreme weather events. According to all the main climate
change scenarios, Italy will be the European nation that is most exposed to damage
caused by its rivers flooding. These phenomena could result in significant losses in terms
of human life and costs in terms of the destruction of public and private infrastructure,
forcing households, firms and the State to allocate a large amount of financial resources
to their reconstruction. The steady increase in temperatures could have permanent
effects on the country's productive capacity.
The effects of climate change on the real economy may spread to the financial
sector through various channels. Natural disasters interrupt the productive functions of
firms and households, increasing their financial vulnerability, reducing the value of the
assets pledged as collateral for loans, and making it more difficult for them to repay
loans. The increase in climate change-related risks could cause banks to tighten credit
towards households and firms in high-risk areas, with possible negative repercussions on
the transmission of monetary policy stimuli. If the scale of these effects were to become
significant, the stability of the financial system itself could be affected. Analyses carried
out by the Bank of Italy highlight the fact that, in our country, more than 20 per cent of
loans to the productive sector are granted to residents in areas with a high risk of flooding;
moreover, the flow of credit is negatively correlated with risk exposure, especially when
the debtors are small and medium-sized firms.
Another type of risk, 'transaction risk', derives from the possibility that the necessary
transition towards a low-carbon economy may occur in a disorderly manner. During this
transition, the prices of energy products may increase markedly: climate policies are
based on the use of alternative energy sources which are currently more expensive, and
on the introduction of carbon-pricing systems, like the taxation of carbon emissions.
Since the short-term demand for energy is not very reactive to price variations due to the
fixed costs associated with changing the sources and forms of supply, a possible increase
in prices would heighten the financial vulnerability of firms and households owing to
the higher cost of purchasing energy goods. A sharp drop in the value of assets and
infrastructures linked to the mining, transformation and use of fossil fuels (coal, oil and
gas) could also trigger a rush to sell the securities of the most exposed companies and
may make it more difficult for them to cover their liabilities towards the banking system
and the market, with consequences that could significantly affect the economic system
and financial stability.
The role of the private and public sectors in the transition
The public sector cannot be solely responsible for creating stable, fair and inclusive
economic growth that respects environmental balances. It is up to the public sector to
create a stable and modern regulatory framework, and to define and implement effective
economic, environmental, energy-related and social policies that provide incentives
that will stimulate new investments. In order to achieve sustainable business practices,
strategies must be adopted that take account of the environment, human rights, consumer
rights, diversity and best practices in corporate governance, i.e. the Environmental, Social
and Governance (ESG) profiles. In adapting to the objectives set by the public sector, the
private sector can draw some advantages. In fact, 'green' sectors are steadily gaining
importance in Italy too. According to Istat estimates, in 2017 the eco-industrial sector
expanded markedly: it contributed 2.3 per cent to total value added and employed nearly
400,000 full-time employees.
Given its critical role in resource allocation, the financial sector plays a key part
in influencing the scope, speed and fluidity of the transition. It can do so effectively if
intermediaries also consider sustainability factors in their corporate governance systems
and in their risk management and investment strategies.
Today, central banks and supervisory authorities also pay close attention to these
issues in carrying out their mandates. They are helping to raise awareness and nurture
a better understanding of the risks related to the sustainability factors and the channels
through which they are transmitted to the financial system. They can disseminate more
data, help develop shared analysis methodologies, and facilitate cooperation and the
sharing of best practices between the various stakeholders in the financial system. They
are trying to provide a good example for all investors through their policies for managing
financial resources and the related risks.
The Bank of Italy as an investor ...
This year the Bank of Italy has decided to adopt an investment strategy that integrates
ESG factors into the management of its equity portfolio, a move that it announced on
its website last week. The principles of diversification and market neutrality, part of the
previously used framework, have been maintained and two new assessment criteria have
been added. The first excludes investments in shares issued by companies mainly operating
in sectors that do not comply with the United Nations' Global Compact, an agreement
signed in 2004 that sets out the principles companies should follow regarding human
rights, labour and environmental sustainability, and measures to prevent corruption. The
second gives preference to the securities of companies with the highest ESG scores.
The new framework significantly improves the environmental footprint of our financial
investments: the new shareholdings portfolio is characterized by lower greenhouse gas
emissions (a reduction of 23 per cent), and lower energy and water consumption (by
30 and 17 per cent respectively). It also follows that risk management becomes more
effective: a comparison of various solutions shows that this approach provides the best
risk-return profile and the greatest protection against particularly adverse market trends.
For the time being, this strategy is being applied to equity investment; an assessment
is under way of the possibility of extending it to other asset classes, such as corporate
bonds. As we work towards further improving the ESG profiles in our portfolio, we
will provide regular reports on the results achieved, so that our best practices and the
methodology we use can serve as a reference for other investors.
Aside from ensuring less risk, sustainable investment does not penalize financial
performance: numerous studies show that it leads to market returns that are not
significantly lower than those achieved using traditional financial models. Good ESG
practices enable firms to benefit from competitive advantages stemming from innovation,
to mitigate operating, legal and reputational risks, and lead to more efficient resource
allocation, all of which tend to lower the cost of capital and to achieve better operational
and market performance. For example, some analyses carried out by the Bank of Italy
have provided clear evidence of a return premium on the shares of European electricity
utilities with lower carbon emissions. Experience has shown that reputational risks and the
risk of serious losses for firms and their shareholders can instead arise from inappropriate
business practices from an ESG point of view.
... and its cooperation with other institutions
The increasing concern about the possible consequences of climate change for the
financial sector has strengthened international cooperation in the field of sustainable
finance, with several initiatives being provided by industry and the institutions. The Bank
of Italy has contributed to these projects and will continue to do so.
In recent years, in our role as members of the Financial Stability Board, we have
discussed the studies of the Task Force on Climate-related Financial Disclosure; we
participated directly in those of the G20 Green Finance Study Group; we are giving
technical assistance to the Ministry of Economy and Finance for the negotiations on the
legislative proposals resulting from the European Commission's Action Plan on sustainable
finance. In this field we have contributed to drafting both the disclosure requirements
as regards the sustainability of the financial products offered to customers by market
operators - including banks, investment firms and fund managers - and the regulations on
new low-carbon benchmarks.
Together with the supervisory authorities of the other EU countries, the Bank of
Italy will cooperate with the European Banking Authority in carrying out the tasks of
identifying the risks that sustainability factors pose to the stability of the financial system,
drafting methodologies to correctly assess such risks, and selecting the most suitable
prudential treatment. It will also take part in the analyses scheduled by the European
Single Supervisory Mechanism, which has included climate change in its risk map for
2019.
The Network for Greening the Financial System was founded In December 2017,
on the initiative of a number of central banks and supervisory authorities. This forum,
in which we participate, has a broad membership at international level, and analyses are
conducted and best practices are shared within it regarding the management of financial
risks linked to the environment and climate change. The Network aims to develop
scenarios, methodologies and studies to integrate environmental and climate risks into
microprudential and macroprudential supervision, collect evidence of the existence of
risk spreads between 'green' and 'brown' assets, and draw up common guidelines for the
adoption of ESG criteria for managing central banks' financial portfolios.
As part of the activities of the Italian Observatory on Sustainable Finance, set up by
the Ministry of the Environment, we carried out a survey in 2018 of Italy's main financial
operators to evaluate their level of preparedness on climate-based risks. The results are
mostly in line with those of other surveys and indicate that awareness of the financial
risks deriving from climate change remains limited. The issue of sustainability is mainly
dealt with from a social responsibility point of view, yet it is generally neglected in the
decision-making processes of administrative bodies and in financial risk management
systems. Greater effort is therefore required on everyone's part in order to focus more
on these topics.
Conclusions
The transition towards an economy with low carbon emissions is essential if we
want to reduce the risks that climate change poses for our well-being. The financial
sector, central banks and supervisory authorities cannot stand in for those who make the
policies necessary to decarbonize our energy systems, but they can play an important
role in promoting this process.
It is in the interests of financial intermediaries to be more aware of how sustainability
factors can affect their activities: it would make it easier for them to take into account
the corresponding risks in their strategies and governance, thereby helping to improve
performance. Central banks and supervisory authorities are working towards making the
financial system ready to face this transition. The spreading of new financial instruments
could be made easier by: the creation of an EU taxonomy of environmentally sustainable
activities and the introduction of [product] labelling schemes (including the standards for
green bonds); the wider uptake of the new low-carbon benchmarks; and the application
of the new rules on disclosure.
Italian investors have expressed considerable interest in sustainable finance, but the
supply of products is still not sufficient to satisfy demand: there is room for new projects
to be financed, we need the right investment instruments, and it is vital that companies
be able to provide the necessary information on the sustainability of their activities.
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