14. 06. 2021 what will be the impact of climate transition on monetary policy? central banking summer meetings pablo hernandez de cos governor ladies and gentlemen, let me start by thanking the organisers for the invitation to speak at these central banking summer meetings. climate change could be a defining issue for our generation. it is therefore natural that climate change has come to the fore of the concerns of policy - makers. and we, financial regulators, supervisors and central bankers, have our share of responsibility too in the joint global effort to tackle climate change. not surprisingly, climate change is one of the key topics in the ongoing review of the ecb's monetary policy strategy or on the work programme of the basel committee. today i will focus, first, on how climate change affect ( a ) the financial sector, ( b ) inflation and ( c ) the natural interest rate. second, i will tackle the issue of what regulators, supervisors and central banks can do to address climate change, within our mandates. climate risks and the financial sector the financial sector is highly exposed to risks associated with climate change by funding other sectors including those exposed to extreme weather events or those that will be affected by the transition to a more sustainable economy. the impact of climate change on the financial sector can, therefore, be relevant for financial stability. and it can also be relevant from our monetary policy perspective, since the transmission of our monetary policy actions to economic activity and inflation operates mainly through the financial system. indeed, a sound financial sector is a prerequisite for a smooth transmission of monetary policy measures to the financing conditions faced by economic agents and, ultimately, to economic activity and inflation. in particular, climate change poses two types of risks for the financial sector : physical risks and transition risks. physical risks are those that would materialise as permanent alterations of the climate, if we do not act to prevent global warming. natural disasters would then become more frequent and their economic damage probably greater. in fact, there is evidence that such risks are already materialising to some extent : according to the fsb1, global economic losses associated with weather - related catastrophes have doubled since the 1990s, up to usd1. 6 trillion over the last ten years. the financial sector is exposed to these physical risks through several channels. physical risks are of course relevant for the valuation of real estate assets, the main collateral for bank loans. physical risks also matter when assessing the ability to pay of borrowers in sectors that could be particularly affected

the main responsibility for addressing climate change resides with governments – namely, fiscal and environmental authorities – because they have the most effective tools and the legitimacy to do so. there is some consensus in the literature that the most effective measure would be to apply pigouvian taxes3 to carbon emissions. the latter, if well - designed, would lead agents to internalise the social cost of their carbon emissions, inducing a change in the relative prices of energy inputs and final outputs in favour of less carbon - intensive ones. that said, preventing climate change requires a holistic approach that involves all policies. careful analysis should be devoted to the interactions of the various policy instruments in the economic sectors affected by transition and physical risks. the final aim should be to define an adequate “ climate policy mix ” that ensures the optimal achievement of environmental targets. in this context, and as part of our main responsibility to guarantee the stability of the financial system, we - regulatory and supervisory authorities - must ensure that the materialisation of climate risks does not endanger financial stability. therefore, we must make sure that financial firms address these risks. in particular, we should contribute to identifying climate - risk drivers and their transmission channels, to the adequate measurement of the economic and financial impact of the different risks, and to the definition and development of the potential mitigation and riskreduction measures. if we succeed in incorporating these risks into the decisions of the financial sector, this will translate into a change in the relative prices of financial instruments. and, in turn, that will help to internalise those consequences originating from both transition and physical risks that affect directly providers and users of funds. this will be a powerful and much - needed complement to the use of the fiscal and environmental instruments that are needed to fight against climate change. in practical terms, climate risk can probably be captured in the traditional financial risk categories ( credit, market, liquidity or reputational risks ). however, several crucial limitations and challenges are coming to light when trying to measure these risks. in particular, there are few sufficiently deep and harmonised databases to analyse and understand the potential effects of physical and transition risks. data granularity is particularly important given the high heterogeneity of the potential impacts. and, while we are working hard to improve available information, we lack sufficient historical depth to be able to use the past as a guide to estimate future developments. in addition, there is no previous experience of structural changes of this magnitude, which also require