Climate related risks from a financial stability perspective Dirk Schoenmaker, Bruegel & Rotterdam School of Management Climated-Related Financial Risks Workshop, Paris 16 December 2016

Agenda Adverse scenario of late and sudden transition Impact carbon bubble on financial system Environmental exposures beyond energy sector Policies Methodology for measurement carbon exposures Developing carbon stress tests Role financial supervisors Develop green finance: opportunity for CMU Conclusions

Adverse scenario: disorderly transition The shift to a low-carbon economy will require significant reductions in greenhouse gas emissions An early and gradual shift can facilitate a “soft landing” in a low carbon economy The adverse scenario is a “hard landing:” Large emissions cuts implemented over a short horizon Amplified by lack of technical progress Constraints on carbon-intensive energy A later transition may also pose larger physical risks from climate change Source: Bank of England, Prudential Regulation Authority (2015)

Link to systemic risk Adverse scenario affects systemic risk via two channels Macro-economic effect due to reduction in energy supply and/or increase in energy costs Sudden revaluation of carbon-intensive assets (carbon bubble), hitting institutions exposed to such assets Effect of channels amplified by policy uncertainty: pricing carbon risk technological uncertainty: costs renewables (solar, wind) may drop frictions in the financial system (feedback loops; expectations)

Example carbon bubble Carbon bubble (i.e. overvaluation of fossil fuel reserves and related assets) is risk to financial system Not only fossil fuels, but also carbon-intensive assets Gradual transition -> gradual write-down Rapid transition -> radical write-downs (stranded assets) Uncertainty: shock can be in 2 or 10 years time!

Environmental exposures beyond energy sector Greenhouse gas emissions and GVA by NACE sector, EU-27 Source: Calculations based on Eurostat data. Notes: Real estate emissions include household heating and cooling costs

Environmental risks and opportunities Environmental imbalances are A risk, that can lead to financial shocks High carbon assets drop, low carbon assets increase in value Externalities of high-carbon are not priced Identify exposures of financial sector through lending / investments An opportunity for financing the transition to low-carbon economy Early transition is preferable Sustainability in the EU 2020 competitiveness agenda To reduce (foreign) energy needs, EU can take lead in green solutions Examples recycling (50% share of world market) and energy efficiency (35%) Enhances productivity and employment

1. Increase transparency of exposures Measure greenhouse gas emissions in full value chain (scope 3) Mandatory disclosure: Non-Financial Disclosure Directive Carbon accounting by financials is increasing Supervisor start to use these data, examples Climate Change Adaption Report by the UK Prudential Reg. Authority Chinese Green Database Nederlandsche Bank in pension sector FSB Task Force on Climate-Related Financial Disclosures (14 Dec) But are data reliable? -> assurance is important

2. Risk analysis Develop carbon stress test to measure vulnerability financial institutions – sector wide (banks, insurance, pensions) New methodologies needed -> emerging best practices Earth is an eco-system -> have to look systemwide (overall carbon budget), otherwise fallacy of composition Interlinkages between carbon assets / economic sectors So, top-down scenario Full scope 3 emissions throughout value chain Finance and Sustainability Risk Forum (at ESRB?) To share best practices across EU financial supervisors To shape EU’s input in G20’s agenda on green finance

3. Risk reduction – public sector To reach climate goals, structural shift in energy consumption Effective carbon pricing Task of European Commission and Governments Major reform ETS (reduction CO2 ceilings following Paris) Carbon tax for industries not covered by ETS If carbon stress tests find material exposures Task of financial supervisors Contain risk through large exposure limits Self-reinforcing effect!

4. Opportunity of green finance – private sector Move from re-active (risk) to pro-active (opportunity) ESG criteria increasingly adopted by large insurers and pension funds Movement from ST to LT investing -> LONG TERM VALUE CREATION Carbon stress test can help raising awareness CMU: Green Capital Markets Plan Tackle inefficiencies in structure of capital markets Benchmarks for ESG performance (with private sector) + assurance EU-wide definition fiduciary duty to include LT sustainable development Templates for LT investment mandates Secure green investment into infrastructure Part of Juncker Investment Plan Green bond standards -> robust standard for ‘green’ projects National capital raising plans for meeting pledges in Paris

Conclusion Adverse scenario highlights ecological risks Measure exposures and conduct carbon stress tests Share best practices in Finance and Sustainability Risk Forum Transparency can raise awareness and change behaviour CMU offers an opportunity to green finance EU could boost efforts in Green Capital Markets Plan EU policymakers set conditions for private sector investment Strengthening EU competitiveness by increasing productivity and employment (first mover on transition to low carbon)

References Advisory Scientific Committee (ASC) (2016), Too Late, Too Sudden: Transition to a Low-Carbon Economy and Systemic Risk, Report No. 6 of the ASC of the ESRB. Schoenmaker and Van Tilburg (2016), Financial risks and opportunities in the time of climate change, Policy Brief, Issue 2016/2, Bruegel.