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

2. 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

3. 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)

4. 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)

5. 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!

6. 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

7. 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

8. 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

9. 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

10. 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!

11. 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

12. 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)

13. 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.