Pandemic risks are not new, but the worldwide scale of the Covid-19 crisis underscores the importance of preparedness and adequate risk management to tackle ‘tail’ events. The virus outbreak is an important reminder of the risks that seem certain to arise from a threat even more ominous: climate change.
If climate risks are not addressed, catastrophic scenarios could materialise, with devastating effects on society, the economy, and the financial system.
The International Monetary Fund’s global financial stability report, published in April, looked at physical risks and their potential impact on financial stability through equity markets. Our analysis shows that global warming scenarios, and the associated projected changes in physical risks, are not reflected in aggregate equity valuations. Investors’ apparent lack of attention could become a significant source of market risk.
Stress-testing and scenario analysis will be important tools of climate-change risk management. Over the past decade, one-fifth of the examinations conducted by the IMF under the Financial Sector Assessment Program has included an examination of climate-related physical risks, with an increasing focus on transition risks. Given the cross-border spill-overs of climate change, taking a global dimension into consideration will be increasingly crucial. Regulatory and supervisory frameworks need to be strengthened, ensuring that supervisors review key exposures of financial institutions to climate risks and measure how they are being managed.
Robust data and disclosures on exposures and vulnerabilities to climate change are critical. Despite recent efforts, significant data gaps remain. Although several disclosure frameworks have been developed, this is a fragmented space that is in urgent need of harmonisation. A consistent set of global disclosure standards, taking into account countries’ legal and institutional framework, will enable markets to accurately price climate-related risks and allow for better-informed decisions by investors and other stakeholders. Higher-quality data, progress towards a broadly agreed-upon taxonomy, and more robust disclosures will help foster sustainable finance and promote sustainable growth.
The task before us is formidable but, fortunately, there is a growing sense of urgency about the climate threat. Thus, there is momentum towards taking the requisite steps to address climate-related risks. The challenge is to remain focused on the priorities, coordinate global initiatives to avoid fragmentation, and ultimately deliver on the promise of building a climate-resilient global financial system.
Fabio Natalucci is Deputy Director of the Monetary and Capital Markets Department, Ranjit Singh is Senior Financial Sector Expert and Felix Suntheim is Financial Sector Expert at the International Monetary Fund.
This article originally appeared in the Sustainable Policy Institute Journal.