Climate change was a hot topic last year; Greta Thunberg was named one of the world’s 100 Most Influential People and activists brought London to a standstill. Central banks are now also debating climate change. Last November, the ECB announced its aim of working toward an enhanced stress test, one which incorporates climate related risks. Since then there have been more and more headlines that link climate change and central banks.

As Mark Carney prepares for his new role as UN special envoy for climate action and finance, December’s announcement highlighted a ground-breaking new stress testing regime – one that tests banks and insurers abilities to cope with three scenarios:

1. Early policy action: an easy and swift transition to a carbon-neutral economy
2. Late policy action: late climate policy action means that we have a delayed transition to meeting global climate targets
3. No additional policy: no new policies are implemented and global temperatures increase above the cap set by global climate change targets

While this is merely a stress-test that forces banks to consider climate change in their risk management strategies, it could however, push them away from polluting investments. The BoE is currently consulting on the design of the stress tests and the first results will be published in the first half of 2021. On the other side of the Atlantic, the Fed has been reluctant to comment on climate change – being regularly lambasted by Trump for its monetary policies, commenting on climate change could add fuel to the fire.

It might be hard to see at first glance why central banks are concerned about the global temperature rise. However, last week’s “Green Swan” report issued by the Bank of International Settlements (BIS) – often described as a central bank for central banks – explained why. The report argues that climate change could trigger the world’s next global financial crisis through a fire-sale that may occur if fossil fuel reserves cannot be monetized, turning many assets into “stranded assets”. This could trigger a global financial crisis. When comparing subprime mortgages with highly polluting “stranded assets” similarities with the 2008 crisis are apparent.

Green quantitative easing
As well as prudential supervision, central banks have powerful tools at their disposal to help fight climate change. “Green QE” is a term that has been used by many to describe central banks’ increase of green bond purchases. However, this is easier said than done. At the end of 2018, the ECB held 24 per cent of eligible green public sector bonds and 20 per cent of eligible green corporate bonds. Skewing any asset purchase program towards green assets risks central banks swallowing the market for green bonds and causing a “green bubble”. Selling carbon-intensive assets is also an option: Sweden’s Riksbank recently announced that it has dumped debt issued by Alberta (Canada) and Queensland (Australia) due to its “large carbon footprint”.

Only a few days before the BoE announced its revolutionary climate change-based stress test, we saw a breakdown of talks between governments at the UN Climate Talks (COP25 in Madrid last December). The talks were meant to define the rules for a new global carbon trading market, which are critical to achieve the Paris Agreement goals. Without governments and politicians playing a leading role in tackling climate change, any input from central banks will be of little or no value. Many central bankers such as Jens Weidmann, the Bundesbank president, have criticized the demands for central banks to fight climate change, stating that “politicians with democratic legitimacy must decide how society should combat climate change and they must also bear the responsibility”.

Whether tackling climate change is within the remit of central banks or not, climate change presents a challenge for the financial sector. Central banks need to ensure readiness for a time when extreme weather and radical climate change policies could severely impact the global economy.

Ahmed Babikir is an associate at Chatham Financial. He specializes in pricing and structuring derivatives for project finance, infrastructure and renewable energy clients. Prior to Chatham Financial, Babikir worked for BNP Paribas and Goldman Sachs. He holds a degree in mathematics, operational research, statistics and economics from the University of Warwick.