Delivering the economic transformation required to limit climate change means something radical must happen to global and national financial systems. Future change is necessary to correctly price climate risk, green the financial system and shift financial flows to sustainable projects.
In most countries, the ministry of finance, their central banks and regulators, and the International Monetary Fund (IMF) make up the finance trinity. These are the three institutions with the most power over the economic and financial system. They are critical to the low carbon and resilient transition, playing an important role in ensuring national finance and economics align with the Paris Agreement to limit global warming. Hearteningly, there is lots of progress being made, but finance must move faster to meet the scale and pace of change required. Let’s have a look at how each element in the trinity is progressing on climate finance:
Looking first at the IMF, Kristalina Georgieva’s appointment as the new Managing Director is bringing a renewed focus to climate change risks, which will now be incorporated into their country surveillance work. Further demonstrating a shift toward climate finance, the IMF’s Finance and Dialogue magazine recently dedicated an entire issue to the economics of climate change.
By identifying climate risks at a macro-level, the IMF is able to understand climate vulnerabilities and opportunities and incentivise action at the national level. This is significant because the IMF’s country reports are often some of the most popular sources of macroeconomic and financial analysis used in some countries. Highlighting climate risks will increase awareness both nationally and for international investors.
Central Banks and Regulators
In other climate finance progress, the Network for Greening the Financial System (NGFS), which comprises central banks and financial regulators from 48 countries and 10 observers, published a guide on the sustainable management of central banks’ portfolios. Moreover, a consensus is emerging from central banks that climate change poses a severe macroprudential threat.
There is also a move toward more activist management of Central Banks’ own portfolios, as opposed to those held for third parties or associated with specific policies such as quantitative easing. However, some central banks – with the German Bundesbank at the fore – argue extending this activism into areas such as green quantitative easing overreaches on their mandate. Efforts by the Bundesbank and others to stick narrowly to their perception of market neutrality is not necessarily the neutral thing to do. Sweden’s Riksbank is moving beyond this concept of narrow neutrality by shifting its foreign exchange portfolio away from carbon-intensive issuers such as Alberta, Queensland and Western Australia. Meanwhile, the Bank of Canada recently recognised the potential of existing fossil fuel reserves becoming stranded. The bank has now launched a research agenda to better understand what the impact of climate change means for the macroeconomy. The European Central Bank’s new President – Christine Lagarde - stated both forecast models and stress tests by the bank should incorporate climate change risks.
The US Federal Reserve is now recognising the impact of climate change across the responsibilities assigned to it by Congress (monetary policy, financial stability, financial regulation and supervision, community and consumer affairs, and payments). The Fed is also closely watching its peer at the Bank of England, considering joining the NGFS and following its lead on stress testing.
Ministries of Finance
Finance ministers, although late to the party, are now taking steps to become more active on climate finance. The Coalition of Ministers of Finance for Climate Action, created last year at the annual UN Climate Conference currently boasts 51 member countries. The coalition helps disseminate best practices and signals commitment at the ministerial level, as well as assists countries in financing their climate action plans. It can also improve climate budgeting, climate strategies and climate risk management. Just this week at COP25 in Madrid, the Coalition unveiled the Santiago Action Plan, an important step towards ensuring finance ministries play their role in accelerating the zero carbon transition.
The climate finance trinity
All three actors in the finance trinity recognise the threats climate change pose to both macroeconomic and financial stability. However, their actions up until now are too cautious and will not be enough to address future climate challenges. For example, The Bank of International Settlement, the central bank’s central bank, emphasises the transition to a new economy must be manageable; but the longer they delay action the more unmanageable the transition becomes. The IMF could help, by extending its assessment of climate risks from country surveillance to more broadly reflect and mitigate the impacts of climate change across all activities in the countries they assess.
The greatest changes will have to come from the ministries of finance, as they are the architects of national economic systems. Finance ministries are ultimately responsible for shaping our economies into the low carbon resilient models we need. Economic and financial climate initiatives taken so far are encouraging, but they need to be expanded and carried through to a successful outcome.
Up until now the key players in the finance trinity have focused on recognising and assessing the macroeconomic and financial risks posed by climate change. However, it is unlikely that identifying risks and waiting for markets to respond will lead to the scale and pace of change required. To truly address the climate crisis, the next phase of financial responses will need to focus on active intervention, rather than risk assessment alone. Moving into that action phase will be the real test of the power of the trinity to guide us into the economic transition that we need.