Shifting to greener, sustainable capital markets should not be seen as an economic risk but as a significant opportunity for growth as technology, job markets and business models develop. To achieve this shift, decisive action must be taken across the financial sector. As climate risk becomes more evident, remaining static is more dangerous than undertaking the uncertain and exploratory transition to a greener economy.

Developing stress testing and scenario analysis tools to examine the impact of climate change on portfolios and assets is integral to making this transition. This was a key conclusion of an OMFIF Sustainable Policy Institute conversation with Sylvie Goulard, deputy governor of the Banque de France, Jim Morsink, deputy director of the monetary and capital markets department at the International Monetary Fund, and Danae Kyriakopoulou, chief economist and director of research, OMFIF.

When discussing the BdF’s work in conducting pilot climate stress tests with French banks and insurers, Goulard highlighted the importance of examining the interaction between transition risk and physical risk. The BdF combines different approaches to achieve this. For global macroeconomic analysis, the BdF uses the scenario analysis approach of the Central Banks and Supervisors Network for Greening the Financial System, focusing in particular on long-term factors (see the April edition of the SPI journal). When examining specific sectors, such as energy, the BdF uses a more granular approach, diverging from the usual stress test exercises developed with aggregated asset classes. This uses the nomenclature of the World Input-Output Tables and underlying database, which comprises 55 activity sectors.

The BDF’s pilot stress tests are not mandatory for French banks and insurers. Goulard argued that at this stage raising awareness and ownership drives better results, and the evidence shows banks and insurers are willing to conduct the exercise, even during the Covid-19 pandemic. She also noted that making the stress test optional means that if the ‘legislator imposes mandatory exercises, people are more prepared and the quality of dialogue improves’.

Scenario analysis of transition risk can provide positive outcomes, as the IMF pilot exercises in Norway examining the risk of transitioning away from carbon-heavy industries demonstrated. Working with the NGFS, Financial Stability Board, World Bank and United Nations, the IMF has established a three-stage approach to analysing risk. First, identify the relevant physical and transition risks in a given country. Second, design climate scenarios related to the risks. And third, map the climate scenarios against macro-financial scenarios and use them to assess resilience in a similar way to conventional stress testing.

As Morsink noted, the Norwegian stress testing pilot revealed that, although sharp increases in carbon prices to enable transition would have a significant economic impact, it would nevertheless be a ‘manageable rise in debt risk’. The impact on banks would be comparable to the 2014 oil price decline. Taking this further, he argued IMF analysis indicates that a ‘steady rise in carbon prices combined with green infrastructure investment could lead to GDP growth and create millions of jobs’. However, to achieve this facilitation of assets and investment, there must be improved reporting of climate-related risk and reporting metrics should be standardised.

Correlating with the need for stronger reporting is the need for improved data metrics. Morsink observed that, ‘Poor data quality is the biggest barrier to sustainability reporting’ and therefore to an effective transition. The only way to assess and fill these gaps is to begin the exploratory work of stress testing and transitioning. On a positive note, however, Morsink highlighted the increasing availability of commercial data.

Building stronger reporting frameworks also requires the development of mandatory disclosure standards and taxonomies, which is a challenging feat. Goulard noted that although the European Union’s sustainable finance taxonomy has been met with criticism, at least it is a step forward. The starting point of the taxonomy is diversity in its risk and energy mix.

To move the economy in the right direction, it is important to define what will be green in the future and find the right way to reach this. It is also important to find a comparable and reliable global disclosure and taxonomy framework. As Goulard argued, ‘The more we converge, the better it is for transition, business growth and jobs.’

Transitioning to a green financial system involves standardised regulation, mandatory controls, appropriate tools and the creation of new market dynamics. There is clear awareness and interest in achieving this, with 90 central banks now members of the NGFS. Morsink and Goulard emphasised the high degree of interest and engagement of the financial sector in adopting stress testing.

Stress testing and scenario analysis also reveal the opportunities created by transitioning and the risks of remaining stationary. We need more central banks, and the financial sector as a whole, to embark on the journey.

Emma McGarthy is Programmes Manager, Sustainable Policy, OMFIF.