Sarah Breeden: Balancing on the net-zero tightrope
Speech by Ms Sarah Breeden, Executive Director for Financial Stability Strategy and Risk of the
Bank of England, at TheCityUK International Conference, 7 April 2022.
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Introduction
Let's be frank. This is not the start to the 2020s that we had all hoped for. A global pandemic
followed by tragedy in Ukraine has led to unimaginable human suffering. And the collective toll on
our livelihoods and economies has been at a scale rarely seen.
Of the many lessons we have learned from these crises, one has particular relevance when
considering the risks to the financial system from climate change and the transition to net-zero
emissions: that managing sharp adjustments in the economy is never easy.
Sudden and large rises in the prices of key commodities, such as oil, natural gas and wheat, are
contributing to economic and financial disruption for households, businesses and governments
around the world. It reminds us that if we want to minimise risks and maximise opportunities, we
need to act early to assess the risks and build resilience against future shocks, whether from
pandemics, geopolitical events, or the transition to net-zero.
The harder question is how we all - governments, central banks, financial institutions and
business - manage the trade-offs we will face along the way. Those trade-offs are environmental
and economic, as well as political, social, and distributional. Managing these effectively is like
walking on a tightrope - with a need to maintain the right balance. Or put another way, it's not just
the destination (net zero by 2050) that matters, the journey (our transition pathway) is important
too.
In the end, the path we take for our planet, economy, and financial system, will ultimately be the
sum of myriad individual decisions, not just big commitments. We must make those decisions in
a timely and informed way with a good understanding of both the intended and unintended
consequences they could create. That is what I would like to explore today. How can we balance
on the net-zero tightrope and what role can the Bank of England, working closely with
government, play in keeping us steady.
The Bank of England's role
Let me start with the Bank of England's role.
As the UK's central bank and prudential regulator, the Bank's role in the transition is to
understand how different transition pathways could affect the macroeconomy, the stability of the
wider financial system, and the safety and soundness of the firms we regulate. Our policy
response must be calibrated to address the risks that these pathways pose to our objectives.
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The Bank's actions can also help magnify the effects of government climate policy , not least
since a resilient financial system will be better able to support the transition.
Mitigating climate change and solving for the transition is ultimately going to take the combined
efforts of government, industry, finance, regulators, and individuals. But while we may all have a
role to play, it is important to remember that they are not the same roles, and that action by one
cannot necessarily substitute for inaction by another. Financial regulations cannot substitute for
government climate policies, and consumer spending choices cannot substitute for public and
private investment.
Climate action by financial firms
That brings me to the financial sector.
A lot has changed in the past few years. We are seeing firms begin to make more serious
investments in developing effective capabilities both to manage climate-related financial risks and
to identify the opportunities from the transition, whether through more sophisticated climate data
analytics or setting firm specific net-zero strategies.
Regulators like us have played a part in prompting this shift, but so too have the demands and
needs of investors and customers. We have seen progress, which is welcome. However there is
still much further to go before capabilities can be considered effective and firms' actions
sufficient to support the transition.
The financial sector's role in the transition is clear. It must facilitate the flow of finance to support
businesses and households in reducing their emissions and help smooth the adjustment in the
real economy.
But there is a problem.
External scrutiny on firms' climate actions is increasing, but this tends to focus on their individual
actions and the greenness of their lending and investments today, rather than the aggregate
outcomes which determine the climate future we face. This approach may lead to firms greening
their own balance sheets today, not greening the future wider economy. And yet the latter is what
is ultimately needed to reach net-zero emissions.
The 'own balance sheet' approach may lead firms or their stakeholders to conclude that they
should simply divest from emissions-intensive companies, assets and jurisdictions. While this
balance sheet-greening - or paper decarbonisation - may reduce the direct risks firms face from
transition, it will not reduce the system-wide risks we will all face, unless those actions mean that
emissions are actually reduced. Put another way, anything one firm does to green its own
balance sheet will be undermined where those emissions-intensive activities can continue to be
financed by alternative sources that will not steward them toward net-zero.
Finance needs to support an economy comprised of both green and greening firms. Importantly,
it also needs to address not only energy supply, but energy demand through improved energy
efficiency. Indeed this week's IPCC reportOpens in a new window revealed that modelled
finance flows for climate mitigation over this decade need to be as much as six times higher than
current levels if we are to limit warming to 1.5°C. Many firms have recognised this and are
increasingly adopting active engagement and stewardship strategies to finance the changes that
are needed. Where this is managed well and there is accountability for delivering change, the
results can yield real world impact above and beyond those that divestment alone can deliver.
The shape and speed of the transition - the signposts for us to follow if you like - is for
government to determine. But it is subject to uncertainty, and the need to recalibrate, given the
long horizons involved. Indeed recent events - and the consequent volatility in energy prices -
suggest that our path to net zero will be bumpier than we would otherwise have expected.
But uncertainty over climate policy cannot be an excuse for inaction by the real economy or
financial sector. The calls for immediate actionOpens in a new window from experts to
reduce our future risks get ever louder. So we must recognise the need to use climate scenario
analysis to explore a range of possible futures as we determine our actions today. Our Climate
Biennial Exploratory Scenario exercise - the results of which we will publish next month - is
designed to do exactly that. We must use exercises like these to help us fulfil our collective
responsibility to manage those bumps well.
The particular size, mix and timing of policy actions, and how they vary across jurisdictions, will
of course have different impacts on different economic sectors and households. Transition to net
zero will create new winners and new losers; some will be better off and others will be worse.
Addressing these distributional effects through a just transition is not the responsibility of central
banks and prudential regulators. But through our analysis we can help shine a light on those
impacts and so support others (government, industry and investors) in their actions.
Unintended consequences
In addition to the intended consequences of policy choices and actions, we may also face
unintended consequences. I want to draw your attention to three that I think we need to be
mindful of.
First, there are policy choices, which could lead to a less effective transition.
I have already mentioned the potential for emissions-intensive activities to migrate outside of the
banking sector. That may lead to less transparency over these activities and could potentially
deprive those firms that need to transition the most access to affordable finance. That does not
mean we should not take necessary actions in the banking sector. But it does highlight that
financial rules are limited by regulatory perimeters.
rapid changes in the prices of green and emissions-intensive assets could lead to
Second,
market instability.
The rush for green investment could create green asset bubbles and increase the risk of sudden
price corrections, especially if greater demand for such investments incentivises greenwashing.
On the other side, sudden imposition of climate policies in a late and disorderly transition
scenario could lead to a climate 'Minsky moment', where prices of emissions-intensive assets
collapse, perhaps with wider financial and economic consequences.
care must be taken in managing the transition to avoid unwarranted economic, social and
Third,
distributional consequences.
We could see this occur where finance becomes the limiting factor for the provision of certain
products or services, restricting their supply before a sustainable replacement has become
available.
That might arise if limits on finance to corporates involved in the supply of high carbon energy
runs ahead of replacement renewable sources. Or if there are restrictions on the provision of
mortgages on energy inefficient buildings without finance available to improve them. Credit being
withdrawn can have wider consequences - for energy prices and the macroeconomy more
broadly. And as recent experience of higher energy prices has reminded us, these impacts can
fall disproportionately on some groups.
Where do we go from here?
We stand at a crucial moment in the transition where momentum is with us but the transition
risks being shaped by firms who are acting with limited information and with the potential for
complex unintended consequences.
Successfully navigating this means we could be on a path to an orderly transition. Failing to
transition in the right way may lead risks to crystallise, the consequences of which could fall
hardest on the most vulnerable.
So how do we ensure that we stay steady as we balance the net-zero tightrope?
An effective transition requires the efficient allocation of capital to assets that are both green now
and those that need greening, and the responsible retirement - over time - of assets which are
not compatible with a net-zero outcome.
Greater detail on government climate policies will support this. But in the meantime greater
transparency on firms' approaches to climate change through disclosures and transition plans is
key to enabling the right action.
We have the foundations for that transparency through the Taskforce for Climate-Related
Financial Disclosures (TCFD) and now the IFRS's International Sustainability Standards Board
(ISSB). On that note, I want to take the opportunity to welcome the UK Government's Sustainable
Finance Roadmap and the Chancellor's commitment to a net zero aligned financial system,
which includes moving to make disclosure of transition plans mandatory. In addition, in the UK
the Climate Financial Risk Forum (CFRF), the industry group which we co-chair with the FCA,
will be making the transition a key area of its work going forwards.
Transition plans, as part of high quality and comparable climate disclosures, will assist investors
and stakeholders to understand how firms are tackling the challenges of climate change.
Crucially they will set out what action is being taken to transition or adapt emission intensive
assets and activities. That will aid the timely allocation of capital to invest not only in assets that
are green now, but also to facilitate the provision of transition finance in support of activities that
seek to reduce their impact on the climate over a responsible timeframe.
And as you may expect from the Bank, we have work underway to monitor and assess the
transition to net zero and to understand how the characteristics could pose risks to monetary
and financial stability, including those I have mentioned today.
Conclusion
I want to conclude by emphasising the point I made at the start. The transition to net zero is not a
destination, it's a journey, and the path we take matters. Given recent events, that path might not
be as direct as we might have hoped.
The urgent need for climate action is hard to overstate. But that should not mean we ignore the
financial, economic, and social consequences that come with our choices as we balance on the
net-zero tightrope.
Let me end with a positive.
Financial regulators' approach to climate change has been developed at pace. A process that
ordinarily would have taken a decade or more to develop has happened in under half that time.
The same is true of the international work on disclosures.
Both remind us of just how much progress has been made recently. That's a sentiment not often
associated with climate change, but one we must build on. After all, there is no safety net if we
fall.
The views expressed here are not necessarily those of the Financial Policy Committee. I am
grateful to Andrew Bailey, Zane Jamal, Timothy Rawlings, Theresa Löber, Chris Faint, and Tom
Daniels for their assistance in drafting these remarks.1