The greening of the financial sector

Speech by Pentti Hakkarainen, Member of the Supervisory Board of the ECB, at the Hannes Snellman Financial Law Seminar, Helsinki, 9 September 2019

Introduction

These days, young people are concerned – more concerned than they have been in a long time. They worry about their future, about the planet, about humanity. They worry that the climate will change so profoundly that life on earth will become much more difficult.

And science supports these concerns. Back in 1988, NASA scientist James Hansen was already telling the US Senate that, for the first time, the greenhouse effect was clearly visible in the temperature record. Today, hardly any scientists would dispute the existence of climate change.^[1] The effects of a changing climate have become tangible almost everywhere and for almost everyone.

Young people, in the meantime, have taken their concerns to the streets. Politicians have come under pressure to act. But actually it’s all of us who are under pressure – to avoid overburdening nature, we have to change our way of life.

Now, you may ask what banking supervisors have to do with all this. Do we have any role to play in fighting climate change? I will discuss this in a minute, but first let’s begin with the economy.

Towards a greener economy – the role of the financial sector

The economy does play a role in climate change. What is produced and how it is produced does have an effect on the environment.

But do prices properly reflect this effect? In other words, do prices reflect the environmental costs of certain products? All too often, the answer is “not at all”, or at least “not enough”. Economists speak of negative externalities. Imagine a coal-fired power plant. Such a plant would release a lot of pollutants into the atmosphere and contribute to global warming. This imposes a cost on society. But would the owners of the power plant take these costs into account when setting the price for the energy they sell? Probably not.

The result is that companies, such as the power plant in my example, make higher profits than they should from a social point of view. In a sense, they are rewarded for putting a burden on nature and society. So there is a problem here that needs to be addressed.

This is not a new insight, of course. In 1920, the economist Arthur Pigou suggested imposing taxes to make companies account for externalities. In the context of climate change, these Pigouvian taxes play a big role; just think of carbon taxes. So it is not surprising that political pressure to implement corrective policies of this nature is increasing.

But it’s not just politics; consumers might change their habits too. And indeed it seems that demand for green products is increasing. The International Trade Centre and the European Commission recently surveyed retailers in five large European countries. About two-thirds of those retailers reported that demand for sustainable products has increased by more than 10% over the past five years.^[2] Following the logic of the market, this would further facilitate the shift towards a greener economy.

And looking at financial markets, investors too have changed their preferences. Institutional investors usually take a long-term view and, as environmental issues have gained increasing importance, they have begun to demand more sustainable investments. Just look at the market for green bonds – it has grown 20-fold since 2013.^[3] As investors start to demand more green investments, supply will follow suit. The economy will move to a more sustainable path.

So yes, the financial sector can bring about swift and profound changes for the better and act as one of the drivers towards a greener economy. But what about banking regulators and supervisors? Should they support the financial sector in its role as an agent of change? Should capital requirements be lower for green assets, for instance?

From my point of view, the answer is quite clear. It is not up to supervisors or regulators of banks to conduct climate politics. Our job is to ensure that banks are safe and sound. Personally speaking, I would love to see an economy that is in balance with nature and social rights. But professionally speaking, it is not my job. As a banking supervisor, my job is to care about the risks that climate change poses to banks. So let’s take a look at some of these risks.

Finance and climate – sketching a risk map

Broadly speaking, there are two categories of risk that we need to talk about. First, there are physical risks, which directly arise from a changing climate. Second, there are transition risks, which arise from the potential shift to a more sustainable economy.

The physical risks have now become clearly visible: heatwaves, droughts, storms, floods, you name it. All this comes at a human cost, of course, and it comes at a financial cost. Insurers estimate that these costs amounted to USD 160 billion in 2018^[4] – which makes it the fourth-costliest year since 1980. And these costs often end up on the balance sheets of insurers and banks.

And as for transition risks, we are talking about massive structural changes in the economy. Such changes always produce winners and losers; carbon-intensive sectors are often said to be among those that might lose out. So yes, a number of assets will have to be revalued – asset stranding is a much-discussed issue in this context. And to the extent that banks are exposed to such assets, they bear a risk.

These are the two drivers of risk we have to deal with, and they share a few features. It is these shared features that make it so hard to handle the risks.

First of all, they are complex, chaotic and non-linear. Climate change might be a gradual process, but it may well come in leaps and bounds. The same is true for the transition to a greener economy. It could happen gradually and predictably, or it could be sudden and disorderly. So it is difficult to properly measure the risks involved.

Second, the risks are spread unevenly. Some regions are affected more by climate change than others. Some are more resilient, others less. Likewise, transition risks are greater for some sectors and regions than for others.

And third, we are looking at a very long time horizon. The changes I am talking about will happen over decades. The risk models used by banks and regulators cover much shorter time frames. This means that there might be blind spots.

All in all, there is a lot of uncertainty. Nevertheless, let me give you a few figures – which you should take with more than just a grain of salt. Regarding the physical risks, there are studies which estimate the value at risk of global financial assets to be as high as USD 24.1 trillion.^[5] For transition risks, the value of stranded assets could reach USD 10 trillion over the next three decades.^[6]

So the risks can be massive, and our 2019 risk map for the banking sector features, for the first time, climate risk as one of the key risks for the European banking sector. Still, we need to learn more about these risks, how to measure them and how to mitigate them.

What should be done?

Currently, we do not know very much about the climate-related risks that banks face. Hard work lies ahead for regulators, for supervisors and for banks. There are many items on our to-do list; let’s look at a few of them.

First, there is the issue of “green” assets. These are generating some hype, and demand is growing fast. There is a catch, though – it is not entirely clear what a “green” asset is. The current definition is a bit like the classic definition of an elephant – you know one when you see one. This is amusing, but it’s not good enough, of course. We need a common and precise definition. We must agree on what a “green” asset is, and what it is not. Importantly, this has to be based on activities, not just on sectors. After all, even within a “brown” sector, there can be “green” activities. The European Commission has made a proposal on defining sustainable assets, which is now being discussed. This proposal just classifies “green” assets, though. To get the full picture, we would also need to classify “brown” assets.

Second, we need to integrate climate risks into our supervisory framework. The European Banking Authority, EBA for short, has the legal mandate to propose an approach.^[7] This proposal will focus on the Supervisory Review and Evaluation Process (SREP) – the main tool of supervisors. At the same time, we need to think about how banks should disclose climate risks. Here, approaches differ across countries and need to be harmonised.

Third, coming back to “green” and “brown” assets, we need to better understand their respective risks. As I already mentioned, it is risks that determine how supervisors and regulators treat these assets. The EBA will work on this over the coming years.

These are just a few of the items on our to-do list. But given the scope of the challenge and its complexity, no one can solve it alone. Regulators, supervisors and central banks have joined forces in a Network for Greening the Financial System. Currently, this network comprises 42 members from around the world, including the ECB, and eight observers. I find it encouraging that so many institutions share a common understanding of the problems we face and have joined forces to come up with solutions. This reflects that there is broad agreement with the views of Christine Lagarde expressed in the European Parliament last week – “that any institution has to actually have climate change risk and protection of the environment at the core of their understanding of their mission”.

Now, what about the banks? How do they approach climate risks? To explore this question, the ECB recently surveyed a sample of banks. The good news is that banks are very much aware of climate change. So far, they have approached the topic from the angle of corporate social responsibility, but they also see the need to approach it from the angle of risk management. So here, too, more work needs to be done.

Conclusion

Ladies and gentlemen,

This brings me to the end of my short speech. We are witnessing a global crisis that will affect almost all aspects of our lives, finance included. As banking supervisors, we have to deal with the risks that climate change poses to banks, and it is true that the journey has just begun. We must now raise awareness among banks. We must better understand the risks and we must find ways to mitigate them. All this is happening right now – that’s the good news.

But what would young people say? For them, this would not be enough, of course. Mitigating the risks for banks does not help to fend off climate change. They see the problem as clearly as Barack Obama saw it, when he said that “climate change is no longer some far-off problem; it is happening here, it is happening now”. Young people are demanding action, here and now. And while banking supervisors have a limited role to play here, the financial sector can – and should – do its part.

Thank you.