What Can Central Banks Do to Take the Paris Agreement Seriously?

Bruegel

Energy

Economic

Summary:

Central banks should take a macro approach to managing system-wide risks stemming from the climate transition.

Executive summary

Since the Paris Agreement on climate change was signed in 2015, its 195 signatories have seen financial instability resulting from the climate transition increase by approximately one third, in the context of still-increasing global emissions. In the European Union, emissions have fallen but banks have not fully internalised the costs of transitioning to net-zero. Banks continue to finance the expansion of the fossil-fuel industry. At the systemic level, this is trading a pretence of financial stability now for a more disorderly transition scenario with greater financial instability later.

Central banks are increasingly using microprudential supervisory tools to address climate-related financial risks. These tools include reviewing banks’ risk-management processes and giving warnings over shortcomings in banks’ risk models. This approach is helpful, but has so far failed to address the build-up of climate-transition-related imbalances in the financial system. This situation echoes the run-up to the 2007-2008 global financial crisis, when supervisors were busy reviewing the implementation of the latest Basel risk models by individual banks, while failing to see increased imbalances in the financial system caused by rising housing prices.

This Policy Brief proposes that central banks should take a macro approach to managing system-wide risks stemming from the climate transition. It is necessary to treat climate as an endogenous, and in many jurisdictions legally-mandated, transition, rather than an exogenous risk. The policy aim for central banks, in their macroprudential supervision capacity, should be to minimise financial instability during that transition. This Policy Brief argues that, all other things being equal, the steadiest path towards net-zero offers the greatest amount of financial stability. Current proposals to impose systemic risk buffers for climaterelated concentration risk may fail to provide such a steady reduction.

A guided transition is recommended for banks that have been reluctant to hive off profitable loans to high-emitting companies. A requirement for the financial sector to reduce financed emissions by four percentage points annually from 2025 to 2050 would deliver net-zero with the least amount of financial instability.

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What Can Central Banks Do to Take the Paris Agreement Seriously?

Executive summary

Risk Disclosure