Climate risk is growing to disruptive levels throughout the financial system and the guardians of financial stability urgently need to adapt their tools to regain control. Finance Watch’s new report calls for economic models that do not mislead, scenario analyses that prepare the market, and a new prudential tool to address the build-up of systemic climate risk.
An uninhabitable hot house
With the world’s current climate action, our planet is on the road of a +3°C average temperature increase: It is becoming a “hot house world” where more than 3 billion people will have to “adapt” to progressively uninhabitable living conditions. Yet policymakers’ economic models predict only a benign level of economic losses from such climate impacts.
Deceiving economic modelling
The cause of such an obvious quantification problem is that the theories behind these economic models rely on backwards-looking data, make assumptions about economic ‘equilibrium’ and use damage functions that are not suitable for modelling an economy disrupted by climate change. Most importantly, the impact of climate change resulting from economic modelling is not compatible with climate science. Yet, the climate scenario analyses conducted by financial supervisors all use these models.
Incentivising supervisory inaction
As a result, the guardians of financial stability are working with highly unrealistic predictions, where the cost of climate inaction is dwarfed and consequently, the small cost of action is seen as too high in comparison. If the cost of inaction were assessed properly, the cost of action would not be an issue for decision makers. Under-estimating the future economic impacts of climate change will reduce our resilience, increase future costs and feed disasters. We need a better choice of economic models and more realistic assumptions.
Improving scenario analyses
The climate scenario analyses conducted by financial supervisors can be easily improved by assessing future economic damages realistically, estimating financial losses from stranded fossil fuel assets and using appropriate time horizons. This should apply primarily to the crucial one-off exercise that EU supervisors are currently undertaking under a European Commission mandate.
A new macroprudential tool for climate risk
Even if economic loss estimates are revised and become realistic, i.e. compatible with climate science, financial supervisors need to adapt existing macroprudential tools to address climate risk: Finance Watch proposes a new ‘loan-to-value’ (LTV) tool for banks’ exposures to fossil fuels that would trigger a capital surcharge once a certain threshold of climate-related risk has been reached, the climate LTV.
The LTV threshold we propose would be set in proportion to the amount of fossil fuels to which a bank is exposed that can be safely exploited within the carbon budget for a given temperature increase:
1. For economic policy makers and financial supervisors dealing with climate risk: make the assessments of the economic consequences of climate change realistic
- Ensure that economic models account for the specificities of climate change, including its magnitude, its irreversibility and its accelerating nature when tipping points are reached
- Ensure that the conclusions of economic models are compatible with the conclusions of climate science, including by rejecting the use of quadratic-only damage functions in loss assessments as those functions are incapable of capturing the specificities of climate change
- Conduct unbiased and rigorous analyses of the results
2. For the European Commission, ESRB, ESAs and ECB: make the EU’s one-off scenario analysis exercise useful
- Ensure that economic models can capture the full effects of climate change in line with the Article 191 TFEU precautionary principle
- Quantify financial institutions’ stranded fossil fuel assets exposures
- Extend the time horizon by several decades beyond 2030
3. For the European Commission and macroprudential financial supervisors: develop a new borrower-based macroprudential tool to address the climate-related threat to financial stability
- Design a loan-to-value threshold that triggers a capital surcharge, applied to fossil fuel assets at risk of stranding
- Make it effective to absorb future losses arising from stranded fossil fuel assets and avoid the build-up of risk
- Base its application by macroprudential supervisors on the quantification of financial institutions’ stranded fossil fuel assets exposures resulting from the EU one-off climate scenario analysis exercise