Speech

Stress-Testing for the Transition to a Low-Carbon Economy

April 15, 2019

Good afternoon, ladies and gentlemen. It’s a pleasure to welcome you at today’s event.

Let me thank our partners at De Nederlandsche Bank — and the Netherlands Executive Director’s office at the IMF — for engaging with us to organize a workshop on this crucial issue. We have had seminars on various climate-related topics — and we will have more in the future — but this is the first one to tackle climate-related stress-testing.

Stress-testing is nothing new for us. The IMF pioneered the use of stress tests for assessing financial stability some 20 years ago. Stress testing has evolved but is still very much at the core of what we do in the Financial Sector Assessment Program. Our stress tests often capture “physical risks” related to climate-related disasters, such as insurance losses and nonperforming loans associated with hurricanes.

However, stress-testing for the transition to a low-carbon economy is a new and rapidly evolving area, and the DNB is at its forefront. I am truly delighted to welcome DNB’s Paul Hilbers and Robert Vermeulen. Together with their colleagues, they are enhancing the public debate on financial stability risks posed by disruptive energy transition scenarios. Before they present their results, let me make five points.

First: Climate change puts our planet at risk, and it confronts humanity with an existential challenge.

• In a 2015 speech, Mark Carney called climate change “the Tragedy of the Horizon.” The potentially catastrophic effects of climate change go beyond the typical horizons of banks, investors, and policymakers. This leads to a major time inconsistency between the costs borne by our generation and those who will follow us.
• The latest report by the Intergovernmental Panel on Climate Change provides dire warnings. Global warming is expected to reach 1.5 to 2 degrees Celsius between 2030 and 2045. Fundamental uncertainties suggest large tail risks and a severe threat of catastrophic outcomes. Weather-related reminders of climate disruptions appear almost daily — from record-setting summer heat waves to historically intense rainfalls; from the gradual melting of Arctic glaciers to the rise of sea levels.
• Breaking “the Tragedy of the Horizon” requires a transition to a low-carbon economy. But, to quote Mark Carney: “The task is large, the window of opportunity is short, and the stakes are existential.” With that in mind, I think we need to prepare for transition scenarios that will be far from smooth. Abrupt changes in policies and technological breakthroughs may change asset valuations, triggering financial instability.

Second: Climate change can pose financial stability risks.

• The financial system has a crucial role in financial protection through insurance and other risk-sharing mechanisms to reduce the cost of disasters when they occur.
• The financial system can play a role in supporting price signals to redirect finance toward clean technologies. But in a disruptive transition, financial system can exacerbate shocks through leverage and interconnectedness, amplifying instability.
• Stability challenges due to climate change are a concern for financial-stability policymakers. he Central Banks and Supervisors Network for Greening the Financial System — which consists of 29 members, including the DNB — identified climate-related risks as a material source of financial risk, and called upon central banks and supervisors to ensure that the financial system is resilient to such risks.

Third: The DNB’s climate-related stress-testing framework is an important step, and it needs to be taken further.

• To better understand financial-stability impacts of climate change, we need new analytical approaches based on forward-looking scenario analysis.
• The framework that our DNB colleagues will present is an important contribution to understanding the risks from disruptive adjustments to a low-carbon economy. The transition risk is one of the main channels through which climate change can affect financial stability, together with physical and liability risks.
• Transition risk is multifaceted. Climate change and the transition to a low-carbon economy are subject to fundamental uncertainty. The complexity of climate risks leads economists and climate scientists into areas that are deeply challenging. The risks of a climate catastrophe have significant breadth, since they affect most business models, sectors, and geographies. They are large, potentially non-linear, and irreversible. They are only partly foreseeable, they depend on short-term actions, and their time horizon is long and uncertain.
• A key next step will be to capture second-round effects — in which a decline in asset prices leads to fire sales, which further depress asset prices, generating a vicious cycle and an amplifying mechanism for an initial shock. Preliminary attempts at quantifying second-round effects suggest that they can be sizeable. It will be essential to fill data gaps — for example, on the industry classification of investment funds’ ultimate exposures. This leads me to the next point.

Fourth: Closing data gaps is critical.

• The Task Force on Climate-Related Financial Disclosures set up by the FSB aims to support voluntary disclosure of climate-related financial risks by the private sector. For now, disclosures are still uneven across asset classes and jurisdictions. Comprehensive climate stress testing by central banks and supervisors would require improved provision and accessibility of high-quality data. Having a well-defined, internationally comparable taxonomy of green (and brown) assets, as well as disclosure standards, would incentivize market participants to reflect climate risks in prices.
• Central banks can take a range of practical steps, for example disclosing their portfolio exposures to climate-related risks. There are still many open questions, such as whether and how to incorporate climate-related criteria in central banks’ portfolio management and other policies. The DNB and others — such as the Swiss National Bank and the Norges Bank — already do so to some extent. And there are broader questions, such as whether climate disclosures should be mandated, as was done for public companies by the French Energy Transition Law.

Fifth and finally: We are open to engage on these topics . The Fund’s overall focus has been on carbon pricing and related fiscal issues. But helping countries ensure financial stability is an important part of what we do, and, in that context, we need to be alert to climate-related risks. We are liaising with central banks and other agencies, and we are working to enhance our analysis of macrofinancial transmission of climate risks, including through stress tests.

The potential impact of climate change compels us to think through these issues with urgency. Let me thank our DNB colleagues for their important contribution to climate-related stress-testing. I look forward to a rich discussion on this vital topic.