It is widely accepted that climate change poses serious threats to financial stability and is therefore relevant to the mandates of central banks and financial supervisors. This recognition was a key catalyst for the creation of Networks for Greening the Financial System (NGFS), an international grouping that focuses on how financial policy must adapt to the risks associated with climate change and the transition to a low-carbon economy. Emerging consensus identifies physical, transition and liability risks as key types of CRFR. CRFRs are unique in their large-scale impact, unpredictable nature and irreversibility. They are also endogenous and systemic, with the potential to affect the entire economy and financial system.

However, measuring and predicting CRFR to support effective financial policy interventions is an emerging area of interest. In particular, there are challenges with the urgency and capacity to translate scientific knowledge into information useful for decision-making. The current policy response focuses mainly on market-correcting strategies, with CRFRs considered undervalued and financial markets too short-term in their outlook. Therefore, policy has focused on encouraging financial institutions to examine and disclose their exposures to CRFRs, in particular through Task Force on Climate-related Financial Disclosures (TCFD) and scenario analysis and stress testing.

However, many questions remain open regarding the assumptions for the scenarios and the relevance of the results for policy interventions. There is a view that insufficient “intellectual capacity” is preventing the adoption of the necessary measures.

Uncertainty and climate-related financial risks

The authors argue that CRFRs, especially transition risks in the short to medium term and physical risks in the long term, are subject to radical or "Knight's" uncertainty, where the probabilities of different outcomes cannot be calculated. This means that sufficient “intellectual capacity” for policy action may never be achieved in advance. Radical uncertainty in relation to environmental financial risks has also been identified by Bank for International Settlements (BIS) a Bank of France.

Risk is usually understood in economics and financial modeling as probabilistic or stochastic risk, implying random outcomes with known probabilities. Conversely, uncertainty refers to a situation where there is no basis for establishing any calculable probability. Under conditions of uncertainty, the future is unknowable and unpredictable. The efficient market hypothesis (EMH) assumes that asset prices fully reflect available information about risks. However, in the presence of radical uncertainty, markets cannot price such assets efficiently.

Although there is some predictability of climate trajectories in the medium term due to the inertia of the climate system, financial risks at the system level remain highly uncertain due to potentially contrasting responses of interconnected economic actors.

Transition risk is particularly associated with significant uncertainty due to human and behavioural factors associated with the transition to a low-carbon economy. The socio-economic responses are large-scale and their financial impacts are largely unknown. Uncertainty is further compounded by the impact of the policy instruments put in place to achieve the transition.

Various sources of uncertainty are exacerbated within a highly complex financial system with unpredictable reactions and interactions between market players, leading to non-linear dynamics and the potential for positive feedback loops and “fat tails”. This endogeneity CRFR, where shocks can originate from within the financial system, is not sufficiently recognized in NGFS reports.

Current approaches to stress testing and scenario analysis have limitations in dealing with long-term horizons, dynamic balances, and the multiplicity and complexity of scenarios. Quantitative modeling cannot compensate for the “unknown unknowns” associated with socio-economic phenomena.

The dominant paradigm of disclosure and risk management implicitly assumes the eventual materiality CRFR for financial institutions over a time horizon that is relevant to financial actors and policymakers. However, the most severe impacts are expected in the long term (the so-called tragedy of the horizon). Although transition risks must manifest themselves in the short term, their current intensity does not seem sufficiently compelling to trigger a voluntary change in the financial sector’s behavior.

In summary, CRFRs are subject to radical uncertainty and the current approach to them is not appropriate. An alternative intellectual framework is needed to guide action even now under conditions of symmetric levels of imperfect information.

A precautionary approach to financial policy towards CRFR: theory and rationale

The document argues that preventive approach to financial policy and regulation (PFP) helps to meet the challenge of radical uncertainty associated with the specificity of CRFR. The PFP framework is inspired by precautionary principle a macroprudential policy.

Precautionary principle and environmental protection

The precautionary principle encourages preventive policies to protect human health and the environment in the face of uncertainty. It is appropriate for “catastrophe” problems, where the system is at risk of total failure and where small and reasonable risks accumulate to some irreversible damage. Given the difficulties in quantifying the risks associated with climate change, the precautionary principle is particularly justified. It is enshrined in international conventions such as United Nations Framework Convention on Climate Change (UNFCCC), Kyoto Protocol a Paris Agreement. It is used in various sectors within the EU. Unlike the direct application of the precautionary principle to new products, preventive policy approach focuses on the systemic risk caused by the financing of a wide range of existing activities at the macro-financial level.

Macroprudential policy as a tool for dealing with uncertainty

Following the global financial crisis of 2007-08, macroprudential policy developed as a tool to address systemic and endogenous financial risks. Rather than regulating individual institutions, it focuses on the stability of the entire system through preventive interventions. Macroprudential policy can be seen as a preventive approach. It allows central banks and supervisors to reduce the likelihood of instability ex-ante, before market participants recognize the emergence of risk. It favors preventive but proactive policies that prevent large losses across scenarios. It involves “bracing against the wind”, ensuring the resilience of the financial system and reducing contagion. Intervention decisions are not based on sophisticated risk modelling, but rather on observations of key indicators and the regulator’s judgment. Given the recognition of the systemic nature of CRFR, there is a strong case for extending macroprudential policy to ensure greater resilience of the financial system to difficult-to-predict climatic financial shocks.

Preventive approach to financial policy towards CRFR: application

The systemic severity and irreversibility of the threats associated with CRFR, as well as the radical uncertainty, justify the development of explicit climate-related precautionary financial policy (PFP), which would encompass all aspects of financial policy. Financial policies and regulations can be used to mitigate the CRFR by supporting a rapid and smooth decarbonisation of economic activity. This could include penalising the financing of unsustainable activities and supporting climate-friendly activities.

Integrating climate risk into capital adequacy requirements

The current capital adequacy framework does not take into account CRFR. A preventive approach would consist of increasing capital adequacy requirements for "dirty loans" (so-called brown penalty factor). A sufficiently high capital requirement would reflect the increasing systemic risk of investing in carbon-intensive activities and would discourage further such investments. Conversely, green support factor, reducing capital requirements for green loans, is problematic due to insufficient capital levels in the banking system and less consensus on what is considered “green”. The focus on penalising carbon-intensive assets has a clearer scientific basis. Some central bank governors have indicated that they would consider introducing higher capital requirements for carbon-intensive loans. There is currently no strong evidence of higher/lower risk for dirty/green loans until an effective transition has taken place. The aim is to support this transition and address the problem of time inconsistency in climate policy.

Climate-sensitive credit checks and guidelines

A more direct way to limit the financing of carbon-intensive activities would be to use quantitative restrictions on lending, such as the ratio of fossil fuels to total loans. The dirtiest forms of lending (e.g. thermal coal) could be banned altogether. A a cap on the level of debt financing of companies exceeding a certain carbon threshold, which would support the resilience of the banking sector to transition risks and would relatively prioritize green activities. A preventive approach would support such interventions even in the absence of environmental legislation. Credit guidelines, aimed at managing credit flows, have been used less in advanced economies since the 1980s, but were common in the post-war period and in East Asian countries to support industrial transformations. They are now being used in many emerging economies to support green finance. This requires better coordination between central banks and governments.

Integrating climate risk into monetary policy operations

Monetary policy operations, including asset purchase programmes and collateral frameworks, also neglect CRFR and are not market-neutral, thus supporting existing “dirty” industries. For example, a significant share of the assets purchased under the ECB’s corporate securities purchase programme come from the most carbon-intensive sectors. The ECB itself has shown a willingness to review its approach, in particular with regard to the principle of “market neutrality”. Currently, the ECB bases the criteria for its asset purchase programmes on credit rating agencies, which do not take CRFR into account globally. Alternative approaches to credit risk assessment attempt to take CRFR into account in central bank operations. A precautionary approach to monetary policy would mean focusing on preventing the worst-case scenarios and adapting financial policy accordingly.

Challenges

Independence, mandates and time horizons

One argument against PFP is that setting policies to restrict or support specific sectors of the economy is the role of the government, not an independent central bank or financial supervisory authority. This argument is less convincing after the last financial crisis, when central banks gained a clear mandate for financial stability. If a precautionary approach is seen as reducing financial risks, it does not seem to undermine the mandate or reduce independence. Politicians may be under pressure not to regulate large companies. A central bank’s inaction on CRFR could be seen as a challenge to its independence. Although PFP requires strong political and public support, independent and goal-oriented central banks should be able to make “unpopular” decisions. The recent shift in central banks’ approach to the principle of market neutrality suggests that they may be open to moving in this direction. Such steps may not be so “unpopular” given the growing societal consensus on climate change. Financial policymakers have an obligation to take systemic risks seriously, regardless of their origin.

Implementation challenges

The implementation of macroprudential tools targeting climate risks is challenging due to the lack of precise indicators. Conditions of radical uncertainty require rather qualitative approach based on experience and judgment rather than sophisticated modeling. It is better to be approximately right than exactly wrong. In an environment of high uncertainty and complexity, simple narratives. A preventive framework for CRFR should be based on concepts such as “rules of thumb”, “bounded rationality”, “learning by doing” and the use of “animal spirits”. Economic institutions play an important role in reducing uncertainty. A preventive approach could consist of shifting the burden of proof (on harmlessness) on financial market participants financing carbon-intensive activities. Financing such activities creates negative externalities and leads to credit market failures. A start could be made with negative screening new loans for fossil fuel extraction. A similar approach can be applied to existing assets. The regulator could issue a list of undesirable activities that financial institutions must stop financing. The precautionary approach justifies the use of heuristic instead of deterministic models. International coordination is needed, but implementation details are context and country dependent. Experimentation with different approaches can be beneficial.

Document proposes acceptance preventive approach to financial policy (PFP) to address financial stability risks arising from climate change. This approach is justified by the radical uncertainty characterizing CRFR, which makes it impossible to effectively use conventional financial risk modelling. The PFP should help justify immediate preventive measures and steer financial markets towards a preferred low-carbon future. Given the global, deep, long-term, systemic and endogenous nature of CRFR, it is appropriate macroprudential approach. Implementation should include integrating CRFR into capital adequacy requirements, monetary policy operations, quantitative credit controls and guidance, as well as strengthening the resilience of the financial system. The PFP framework should also contribute to strengthening existing measures, such as risk disclosure and taxonomy, by making them mandatory and standardised. Policymakers should be aware of the short-term trade-offs between efficiency and resilience and the expected resilience of market actors with shorter time horizons. In this new environment, ‘learning by doing’ is needed. More valuable information can be gained from interventions and the study of subsequent reactions than from non-interventionist analysis. Changing the intellectual framework of financial policies is a long-term task. Future research should focus on a deeper analysis of possible instruments and policies. In addition to central banks and supervisors, other branches of government will also have a role to play. While more knowledge on CRFR is welcome, the research timeframe needs to be aligned with the timeline of policy decisions. The PFP framework could be extended to other complex environmental challenges. Spring

Glossary of key terms

• Climate-related financial risks (CRFR): Financial risks arising from the impacts of climate change and the transition to a low-carbon economy. These include physical risks, transition risks and liability risks.
• Radical uncertainty: A situation in which it is impossible to calculate the probabilities of different future outcomes because the future is unknowable and unpredictable. Sometimes referred to as "Knightian" uncertainty.
• Precautionary principle: The principle that states that where there are threats of serious or irreversible damage, lack of full scientific certainty should not be a reason for postponing cost-effective measures to prevent environmental deterioration.
• Microprudential policy: Financial regulation and supervision focused on the safety and stability of individual financial institutions.
• Macroprudential policy: Financial regulation and supervision aimed at the stability of the entire financial system and the prevention of systemic risks with an impact on the macroeconomics.
• Capital adequacy: The ratio of a bank's capital to its risk-weighted assets, which is regulated to ensure that banks have sufficient financial reserves to cover unexpected losses.
• Monetary policy: A set of tools used by a central bank to manage the money supply and interest rates in order to achieve macroeconomic objectives such as price stability and full employment.
• Stress testing: Analysis of the potential impacts of adverse scenarios and shocks on financial institutions or the entire financial system.
• Scenario analysis: A method of examining possible future scenarios and their impact on financial assets, portfolios, or institutions.
• Market neutrality: The principle that a central bank's monetary policy operations should not favor or disadvantage any particular sector or asset in the market.
• Brown penalising factor: Proposal to increase capital requirements for loans and investments related to carbon-intensive activities.
• Green supporting factor: Proposal to reduce capital requirements for loans and investments related to environmentally sustainable activities.
• Credit guidance: Policy instruments aimed at influencing the direction of credit flows to certain sectors of the economy.
• Systemic risk (Systemic risk): The risk that the failure of one financial institution could trigger a cascade of failures throughout the financial system, which could have serious consequences for the real economy.