Regulators and central banks won’t solve climate change on their own

Political will and carbon pricing needed to stop the world from warming

The earth is getting warmer. Climate change will lead to more extreme weather events, such as droughts and floods, which can destroy crops, buildings and infrastructure. Measures to curb global warming will affect the structure of the economy. The goal of the Paris agreement is to limit global warming to two degrees celsius and preferably no more than one-and-a-half degrees. To achieve this, greenhouse gas emissions must be cut sharply. A number of countries have committed themselves to reducing emissions markedly compared to 1990 levels by 2030, aiming at low-carbon economies by 2050. Achieving this goal requires an economic restructuring – through new instruments, changes in preferences and technology.

Climate change and the transition to a low-carbon economy will be one of the biggest challenges for companies and investors over the years to come. Borrowers who are unable to cope adequately with these changes will pose risks to the banking sector.

Faced with climate-related financial risks of uncertain implications, regulators are setting expectations and prescribing requirements for the disclosure of climate-related financial information. An important initiative to promote more effective corporate climate disclosure to support investment decisions is the Task Force on Climate-related Financial Disclosures. The TCFD encourages disclosure on how companies consider climate change factors in their governance, strategy and risk management. It has played a pivotal role in promoting more standardised corporate climate disclosure and has led to a series of regulatory developments at a global scale. In 2020, New Zealand became the first country to implement mandatory disclosures by financial institutions in line with TCFD recommendations. The UK government announced its intention to make TCFD-aligned disclosures mandatory across the economy by 2025.

Despite risks to companies and investors, climate change also provides economic opportunities. Some companies are exploring ways to strengthen their competitive position or develop products to access untapped market opportunities. Companies can also realise efficiency gains and cost reductions by increasing resource productivity, reducing energy consumption and strengthening supply chains to minimise climate-related disruptions. Companies also have the opportunity to invest in adaptation measures to make themselves more resilient to climate change.

Although the economic and financial impacts of climate-related events are becoming more evident, opinions differ on the extent to which markets are already pricing climate risks and under what conditions they can be expected to do so. There is a lack of sufficient evidence to claim that climate risk is systematically mispriced. This creates dilemmas for regulators. On the one hand, there is a need to ensure climate risks are being sufficiently addressed. On the other hand, if there is really not much that regulations could add to what the market already knows, there is an obvious danger of regulations being either excessive or misplaced.

Climate change is a global challenge that political authorities must first and foremost meet with instruments other than those available to central banks and regulators. Over time, carbon pricing is the only route forward to combat global warming. Central banks and supervisory authorities may, within their mandates, promote financial stability by ensuring that the financial sector includes climate risks in their assessments, communicates relevant information and ensures that all risks are backed by sufficient capital.

Øystein Olsen is former Governor of Norges Bank and Member of OMFIF’s advisory council.

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