08.04.2022
Sustainability and climate change: measurement and management
challenges*
"Private capital: investment with an impact" / Annual congress of the Asociación
Española de Capital, Crecimiento e Inversión (ASCRI)
Pablo Hernández de Cos
Governor
*iEnglish translation from the original in Spanish.
Good morning.
I should like to begin by thanking the Asociación Española de Capital, Crecimiento e
Inversión (ASCRI) for inviting me to participate in their annual congress.
This congress is today going to address environmental sustainability, one of the main
challenges facing our society, as we have very recently been reminded by the
Intergovernmental Panel on Climate Change (IPCC). As you know, the IPCC has just
published the third part of its Sixth Assessment Report, which stresses that we are still in
time to limit the temperature increase by the end of the century to 1.5oC, although immediate
and decisive measures are required.1
In particular, the transition to a more sustainable economy (one that generates lower
emissions) requires a very significant volume of economic resources. In the European Union
alone, according to European Commission estimates,2 complying with the emissions
reduction target set for 2030 requires investing approximately an extra €350 billion per year
over the current decade. The financial sector clearly needs to be involved in mobilising this
enormous volume of resources.
Given our mandate to preserve financial stability, the contribution of supervisors and
financial regulators to the achievement of these targets involves ensuring that intermediaries
identify, measure, manage and disclose the financial risks associated with climate change.
Undoubtedly, the incorporation of these risks into their management decisions will help to
change the relative prices of financial instruments in favour of those that fund more
sustainable activities, thereby reinforcing the impact of other public policies.
Today I wish to take this opportunity to describe the actions we as supervisors and financial
regulators are taking at global level for this purpose. I will start by identifying the financial
risks associated with climate change and the main channels of transmission to financial
institutions, and then analyse the specific features of these risks, as well as the regulatory
and supervisory initiatives adopted in the banking field.
Risk factors associated with climate change
Climate change risks may be divided into two types: physical risks and transition risks.
Physical risks are those that arise when climate change materialises, to a greater or lesser
extent. This leads to extreme weather events, a rise in sea levels, desertification, greater risk
of wildfires, etc. In the case of Spain, the National Plan for Adapting to Climate Change
2021-20303 suggests that these risks have already started to materialise. Also, according to
the European Environment Agency, extreme weather and climate events have already
caused direct economic losses in Spain totalling more than €60,976 million since 1980.4 The
European Commission estimates, in its 2020 report,5 that a global temperature increase of
3°C could result in an annual welfare loss of around 1.4% of GDP in Europe, with the
greatest impact arising in southern Europe.
Meanwhile, transition risks relate to the costs that may arise during the transformation of
the economy needed to mitigate climate change and minimise the impact of the physical
risks. The implementation of public policies necessary to achieve these objectives, the
development of less contaminating technological innovations and changes in consumer
preferences in favour of lower-emission goods and services will lead to a reallocation of
resources between sectors. If this is not a sufficiently smooth process there could be
significant economic disruption.
Channels of transmission to financial institutions
Financial institutions are exposed to the above-mentioned risks both directly and indirectly.
This issue has been addressed by various studies and institutions. For example, in the
banking field, the Basel Committee on Banking Supervision (BCBS) published a paper in
April 20216 dividing transmission channels into two groups: microeconomic and
macroeconomic.
Microeconomic channels refer to the effect that the above-mentioned risk factors may
have on institutions' counterparts (borrowers). Macroeconomic channels refer to the
negative effect that physical and transition risks may have on economic growth, which
would also affect financial institutions.
To illustrate these channels, transition risks may, for instance, arise from the introduction of
green taxes, which would raise energy costs. This increase in costs may, in turn, drive up
the prices of those goods whose production requires more energy and, subsequently, a
decrease in the demand for them, affecting firms' revenues. Household real income would
also be affected.
New greener technologies may reduce these energy costs due to their greater efficiency,
but they may also increase firms' leverage, on account of the need to invest in these new
production processes. In the case of households, investment and adaptation will be needed
in personal transport and housing.
Also, the transition could generate a change in consumer preferences, in favour of greener
goods and services. This would involve changes in relative prices that would affect firms
and sectors unevenly.
As regards the impact of the physical risks, damage to physical capital, including housing,
and production disruption as a result of the materialisation of these risks would affect
institutions' revenues and costs, and also the value of collateral and wealth. For one thing,
insurance and maintenance costs will rise, causing an overall increase in companies' costs.
Furthermore, physical capital damage would necessitate new investment, which would
increase leverage. Additionally, revenues would also suffer from these risks due to their
negative effects on production capacity. From a more macro perspective, these risks may
impair productivity and also cause a reallocation of resources, not only of physical capital,
but also of labour, through migration.
Special features of climate change risk factors
In general, these risks can be considered to manifest themselves in financial institutions
through the traditional financial risk categories (credit, market, liquidity, operational and
reputational risk).
However, climate change incorporates some fundamental special features into these
traditional risks, which must be taken into account if they are to be managed and supervised
appropriately.7
First, the consequences of climate change are unprecedented and will occur over a very
prolonged period. Historical experience is thus of little use to assess their magnitude and
evolution, and therefore the uncertainty associated with how and when they will materialise
is very high.
Second, that uncertainty is exacerbated by the fact that the physical and transition risks
are interrelated non-linearly, and possibly subject to tipping points. This, in essence,
means that the magnitude of the effects of their materialisation could be greater than
expected and will affect economic agents more generally and more abruptly than other
risks.
Third, the problem has a global dimension. There is little any one country can do on its
own to avoid the problem and there may always be free-riders. That is why utmost
collaboration and cooperation are required. International organisations and institutions
therefore need to play a key role in this area.
Fourth, the impact of the materialisation of the physical and transition risks of climate
change may be very uneven across geographical areas and economic sectors.
Moreover, apart from this geographical and sectoral diversity, the impact is also likely to be
very uneven across economic agents.
Given these special features, we banking regulators and supervisors have launched various
initiatives to assist and oblige banks to take these risks properly into account. Thus, the
European Banking Authority (EBA),8 the European Central Bank (ECB)9 and the Banco de
España10 have each published supervisory guidelines and expectations explaining how
banks are expected to consider these risks in their daily operations, their business strategies
and their risk management. At global level, the BCBS has published for consultation a paper
on principles for the effective management and supervision of these risks.11
In any event, the improvement in banks' management capability will presumably have to be
supplemented by the development of a regulatory and prudential framework that properly
takes into account the special features of the risks associated with climate change. There
are two preliminary issues here: the existence of information and common taxonomies and
the development of measurement methodologies.
The need for common definitions and granular data
To assess climate risks correctly, first it is necessary to have common definitions and data
of sufficient quality and granularity. The Network for Greening the Financial System (NGFS),
of which we, among 108 central banks and supervisory authorities from all over the world,
are members, published in May 2021 a report12 emphasising the importance of having
common worldwide definitions and standards for disclosure of information associated with
these risks.
Common definitions
Owing to the complexity of the matter, the progress made towards establishing a global
taxonomy is, unfortunately, still limited. Not only are productive technologies characterised
by great heterogeneity at any given moment in time, which affects their environmental
classification, but also a dynamic approach, which recognises the progress made in
reducing their emissions, needs to be adopted.
I would, however, like to stress the impetus the European Union has given to this issue,
through the Taxonomy Regulation,13 which sets the foundations for a common European
classification of "environmentally sustainable" economic activities. The regulation
establishes six environmental objectives. An economic activity qualifies as sustainable when
it contributes to one of these objectives without causing significant harm to the others, and
complies with certain minimum social safeguards. For example, economic activities with
low CO2 emissions (such as solar power production) qualify as sustainable as they
contribute to mitigating climate change, as do activities that have no viable low emissions
alternative but support the transition by gradually eliminating CO2 emissions.
This classification is the cornerstone of the European sustainable finance agenda and
provides the basis for all sustainability regulation. The European Commission is currently
working on completing this taxonomy, extending it to so-called "brown" and "neutral"
activities.
Disclosure
In November 2021, during the COP26, a decisive step forward was taken at international
level on disclosure. The IFRS Foundation announced the creation of the International
Sustainability Standards Board (ISSB), to establish global sustainability-related disclosure
standards. This initiative could be of comparable importance to the creation of the
International Financial Reporting Standards 20 years ago.
At European level, the European Commission's proposal for a Corporate Sustainability
Reporting Directive (CSRD) is also a significant step forward in terms of improving the
information available to market participants and supervisors. This initiative, still in the
negotiation phase, revises and strengthens the sustainability reporting standards for
companies operating in Europe and establishes mandatory sustainability reporting
standards for more than 50,000 firms, including all large and listed firms, although simpler
standards will apply to listed SMEs.14
In January this year, the EBA published disclosure standards for environmental, social and
governance (ESG) risks. These provide the basis for publication by the European banking
sector of comparable quantitative information on how climate change risks affect their
balance sheets. Compliance with these standards will undoubtedly require a significant
effort on the part of banks, which ultimately depend on the information available on their
counterparties. As a result, the EBA has introduced certain transitional features in the
standards to facilitate the adaptation process. In any event, providing this information to the
market will encourage banks to improve their information systems and databases.
Moreover, improving public information will ultimately enhance the ability of financial market
participants to discriminate.
The BCBS is playing a notable role globally. In November 2021 it publicly communicated its
support for the creation of the ISSB.15 At the same time it indicated its intention to explore
in parallel how to use the bank disclosure framework (Pillar 3) to promote a common
disclosure baseline for climate-related financial risks across internationally active banks.
Importance of scenario analyses and stress tests
A second challenge arises from the lack of satisfactory analytical tools to measure the
impact of climate change on traditional financial risks and on the resilience of banks and the
financial sector as a whole.
Scenario analysis exercises and stress tests are particularly appropriate: their
forwardlooking nature and the ease with which numerous assumptions can be included make them
especially suited to measuring these risks.
These instruments are not new. Indeed, they have been used by supervisors for prudential
purposes since the last global financial crisis. However, some significant adaptations are
needed to capture the complexity and uniqueness of climate risks.
In this respect, the BCBS published a report in 2021 analysing the main problems that arise
when measuring these risks.16 Essentially, three difficulties stand out: the complexity
associated with the design of different physical and transition climate-risk scenarios, the
need to incorporate different time horizons into the assessments and the operational
problems involved in carrying out these exercises, in terms of the data and resources
required.
As regards the scenarios, the NGFS has developed a set of scenarios intended mainly for
central banks and supervisors, which may also be useful for stress tests for financial
institutions. These scenarios are plausible representations of the future consequences of
climate change depending on the severity of the physical damage and the speed and
effectiveness of the policies rolled out globally to support the transition to a sustainable
economy.
Specifically, an extreme scenario is defined, based on the assumption that no measures
are taken to mitigate climate change, which would naturally entail materialisation of the
physical risks.
An alternative scenario involves an orderly transition, in which the measures necessary to
reduce the volume of CO2 emissions in accordance with the Paris Agreement are taken
promptly and progressively. As the measures are introduced gradually, the physical and
transition risks are considerably reduced.
Disorderly transition is a third scenario, under which measures to combat climate change
are not taken until a relatively late stage, so that it is necessary to reduce emissions to a
greater extent than under the orderly transition scenario in order to achieve the same
emission reduction target. As a result, the transition risks increase.
A growing number of central banks and financial supervisors have begun to carry out climate
change stress tests, making use of these scenarios, adapted as necessary to reflect the
specific features of each economy.
In September 2021, the results of the ECB's stress tests were published. They covered
approximately 4 million companies worldwide and 1,600 consolidated banking groups in
the euro area and incorporated the impact of both physical and transition risks over a
30year period.
The results show that the long-term benefits of early adoption of policies boosting the
transition to a carbon-free economy more than offset the short-term costs of this transition.
They also show that if climate change is not mitigated, the materialisation of the physical
risks will generate large economic losses, which would be greater in certain geographical
areas, with particularly significant effects on banks exposed to these areas.
In terms of their impact on economic activity, the differences between these scenarios are
considerable. The short-term cost, in terms of GDP, of measures to mitigate climate change
will be greater the later they are implemented. Even so, by the end of the time horizon of the
exercise, GDP would be approximately three percentage points lower under the disorderly
transition scenario than under the orderly transition scenario, and six percentage points
lower under the scenario of no significant measures.
These impacts on economic activity lead to a deterioration in the financial situation of
businesses and, consequently, in their ability to pay their bank debts. Also, the
materialisation of climate risks impairs the quality of bank collateral and increases the losses
in the event of default. Given these results, the ECB estimates that the expected losses for
the banking sector arising from the impairment of the credit quality of its counterparties and
collateral would amount to approximately 3.5% and 8% in 2050 under the disorderly
transition and measure-free scenarios, respectively. European banks would also face
impairment of their corporate bond holdings under these scenarios, further reducing their
profitability and solvency. As already mentioned, the impact would be uneven across
economic sectors and geographical areas, and therefore the effects on banks across
different countries would also be uneven.
A very important point here is that banks' potential response to the materialisation of risks
is not currently modelled in these stress tests, since the aim is to show what would happen
precisely in the absence of any such response. In reality, however, banks can be expected
to respond to the increase in the probabilities of default associated with the materialisation
of physical risks in the event of inaction, which would exacerbate the negative implications
for activity in these areas. The possibility of response makes the climate stress test
methodology even more complicated, but it is a key element which will have to be
incorporated in future.
In addition, the ECB is currently conducting bottom-up stress tests in which banks will
assess their exposure to climate risks. The exercise began with a questionnaire for banks,
the aggregate results of which are due to be published in the summer.
At the Banco de España we have also carried out top-down stress tests to assess the
resilience of the Spanish banking sector to climate-related transition risks,17 and we are
currently carrying out various empirical analyses to approximate the potential impact of the
physical risks.
In the first case, we simulated the impact of different transition policies over a three-year
horizon: 1) a rise in the price of CO2 emissions to €100 per tonne; 2) extension of the
obligations to acquire emission allowances for the most polluting sectors to all other
productive sectors; 3) a combination of the previous measures, which would be compatible
with the aim of achieving net zero emissions in 2050; and 4) a combination of these same
measures with an extension of the emission trading system to households.
Given the time horizon of the analysis (three years), these scenarios seek to calibrate the
initial cost to the Spanish economy of the transition to a green productive model.
The results show that the cost of applying these policies in terms of economic activity would
be moderate over the first three years, although highly uneven across sectors. Also,
according to this exercise, the Spanish banking sector could absorb the impact of the
increase in costs of productive sectors that would be generated by an ambitious climate
transition policy, without significant impairment of its solvency.
At the same time, as I have already said, we are working to measure the costs of failing to
act on climate change. In this respect, certain episodes have already been observed that
enable this cost to be approximated to some extent. One of these episodes - the
degradation of the Mar Menor - has been analysed by our economists.18 Using econometric
exercises, they estimated that the ecological deterioration has already had a significant
negative impact on the value of housing in the areas affected; in cumulative terms, house
prices have risen by approximately 40% less than in comparable areas that have not
suffered a similar impact. For the banking sector, the loss of value of residential housing
obviously entails a lower value of the available collateral and increased risk in the event of
impairment of the loan portfolio, and especially of mortgage loans. More generally, this
exercise shows that the materialisation of climate change may have a significant impact on
the economy as a whole.
Conclusions
To conclude. I have referred today to various initiatives that show that we financial regulators
and supervisors, within our mandates to guarantee financial stability, can (and should)
actively contribute to international action to combat climate change. To ensure that the
relative prices of financial instruments change, and thus to help internalise the
consequences of climate change, it is essential that financial market players identify climate
risk factors and their transmission channels, measuring their economic and financial impact
appropriately, and that they disclose their exposure to these risk factors and define and
develop possible measures to mitigate and reduce them. This is necessary to supplement
the fiscal and environmental instruments required to achieve the environmental targets.
Allow me to finish by emphasising the global nature of this strategy. Climate change is a
phenomenon that affects the whole planet. Globally coordinated action is needed to
address it, including, of course, in the financial sphere. This is the perspective that informs
the Banco de España's firm commitment to do its utmost to contribute, within the scope of
its responsibilities, to this common task of combating climate change.