Tuesday, Feb 21, 2023
A Climate and Biodiversity Risks Toolkit for Financial Supervisors - 2023 Update
Climate and biodiversity-related risks to financial institutions, financial stability, investors, and financial inclusion are increasing. These risks are therefore becoming increasingly important to whether financial supervisors – across all sectors – can meet their mandates and objectives for the safety and soundness of supervised firms, financial stability, consumer and investor protection, and financial inclusion.
Financial supervisors’ understanding of climate-related risks has broadened and deepened in recent years. Increasing attention is also beginning to be paid to the implications for financial supervisors of biodiversity risks arising from the loss of habitats and species, the loss of genetic diversity within and between species, and the loss of ecosystems.
This Toronto Centre Toolkit is designed for financial supervisors in emerging markets and developing economies, who are considering how best to respond to climate and biodiversity-related risks, or who have made progress in this area but want to check that they have covered the right topics and are headed in the right direction.
The main objective of this Toolkit is to build supervisory capacity in factoring climate and biodiversity-related risks into the assessment of the risks facing financial institutions and of financial stability more generally; the assessment of areas where consumer or investor protection may be needed, including through standards of disclosure to enable investors and consumers to make well-informed decisions; and addressing the impact of climate change and biodiversity loss on financial inclusion.
Work on climate-related risks to the financial sector is generally more advanced than on biodiversity- related risks, including in terms of disclosures, metrics, definitions and analytical approaches.
However, biodiversity-related risks to financial institutions, financial stability, consumers and investors, and financial inclusion may turn out to be more important than climate-related risks for some countries and for some financial institutions. Climate and biodiversity-related risks may also interact as more or less equal partners in a damaging way. So it is important that supervisors - and the firms they supervise - consider both risks.
Moreover, it is efficient to consider both risks together because the impacts of both risks can be considered within the same physical and transition risk transmission mechanisms framework.
This Toolkit addresses four broad questions corresponding to the steps that a supervisory authority should take when addressing climate and biodiversity-related risks to its supervisory objectives.
For each question, the Toolkit provides an overview of the key issues for a supervisory authority and a list of key resources to enable supervisors to explore each issue in more detail:
- What might be the impact of climate change on your country?
- What might be the impact of climate-related risks on financial institutions, on financial stability, and on users of financial products and services in your country?
- What supervisory actions should be taken in response to climate-related risks?
- Can and should supervisors do anything to influence climate change itself?
OUTLINE OF THE TOOLKIT
THE IMPACT OF CLIMATE CHANGE AND BIODIVERSITY LOSS ON YOUR COUNTRY
Supervisors need to understand how climate change and biodiversity loss might affect their country and its economy, as a starting point for considering the potential impacts on the financial sector.
Climate change and biodiversity loss are similar in the sense that both are already occurring, with damaging consequences; are also of a long-term, uncertain, potentially far-reaching severe and potentially irreversible nature; may exhibit non-linearities, tipping points and “cliff effects”; and could be (and in some countries already are) of systemic importance to economies and to financial sectors.
Climate change is one of the main drivers of the biodiversity loss so, to some extent, biodiversity- related risks are a sub-set of climate-related risks. Biodiversity loss is another transmission mechanism through which climate-related risks may have an impact on people, the economy, and the financial sector. Moreover, biodiversity loss can cause climate change – for example through the loss of carbon-absorbing ecosystems - and this inter-relationship can result in mutually reinforcing downward spirals. Climate change and biodiversity loss are therefore best considered together.
However, biodiversity loss can also be caused by other factors, such as changes in land use and land degradation, deforestation, pollution, the use of fertilisers and pesticides, and the introduction of invasive species.
There is a high probability that a combination of physical and transition risks from climate change and biodiversity loss will materialize in the future and will interact in complex ways, resulting in unpredictable environmental, geopolitical, social, economic and financial sector dynamics.
The nature and consequences of climate change and biodiversity loss will differ across countries. Key vulnerabilities at a national level typically include changes to the physical environment, the transition to a low-carbon and more biodiverse economy, and other impacts of climate change and biodiversity loss. The nature of these vulnerabilities will depend in part on the magnitude of the climate change and biodiversity loss, and in part on national dependence on the industries likely to be most affected, such as fossil fuels, agriculture, fishing and tourism.
In many cases the impacts of climate and biodiversity-related risks on an economy will be significantly affected by the wider public policy response to these risks. Supervisors should therefore be aware of key public policy commitments and initiatives in their country, such as net zero commitments or transition/adaptation plans. They may be asked to deliver their supervisory mandates in a way that is consistent with these broader public policy goals.
CHANGES TO THE PHYSICAL ENVIRONMENT
Climate change and biodiversity loss change the physical environment.
Climate change has already resulted in higher temperatures, more extreme regional and local weather conditions, rising sea levels, and more frequent weather-related disasters (including droughts, flooding, hurricanes and cyclones, and extreme heat, cold and precipitation events).
Biodiversity loss can undermine the ecosystems on which human society, economies and other species rely. These ecosystems include those providing food, raw materials, fresh water, air quality, pollination, and pest and disease control.
The physical changes caused by climate change and biodiversity loss can have a direct impact on physical assets (residential, commercial and public sector properties); utilities (electricity, gas, water, sanitation, communications, and transport infrastructure); food systems, including agricultural production (crops and livestock), fishing and food supply chains; manufacturing capacity; and tourism.
These impacts may, in turn, have an adverse impact on the economy across the household, corporate and public sectors. There may also be pronounced regional and sectoral impacts.
Vulnerability to physical risks may be greater where there are less developed mechanisms through which to share risk or to respond to risks when they crystallize. This may coincide with broader macroeconomic vulnerabilities. For example, the ability to recover from weather-related natural disasters may be limited by fiscal constraints and under-developed insurance markets.
TRANSITION TO A LOW-CARBON AND MORE BIODIVERSE ECONOMY
A transition to a low-carbon and more biodiverse economy may create sharp and substantial shifts in the value of some assets.
Government actions and policies to reduce greenhouse gas emissions or to protect biodiversity, technological developments, and shifts in consumer and investor preferences, can all lead to shifts in asset values and in patterns of the supply and demand for goods and services, nationally and internationally. Examples of government actions and policies include carbon taxes; subsidies for renewable energy and adaptation; land, forest and other natural resource protection; bans on coal and other fossil fuel production; bans on importing unsustainable natural resources; and building and transport regulations.
Countries that are more dependent on fossil fuel production and refining, timber, and the production of fertilisers and pesticides, may be more vulnerable to transition risks, with an impact not only on the value of companies involved in these sectors, but also more widely on economic growth, employment and government revenues.
Shifting investor and donor country behaviour may result in a challenging environment for governments and utilities to finance new public infrastructure such as power plants reliant on fossil fuels or large-scale hydro-electric plants relying on dams that flood ecosystems. The availability and reliability of public infrastructure can in turn be a critical determinant of private sector investment.
There may be trade-offs between physical and transition risks. For example, a rapid adjustment to a “net-zero” and more biodiverse economy could be associated with higher transition risks, even if it reduces the physical impact of climate change. Alternatively, a failure to adjust will lead to more pronounced physical risks and probably much larger transition risks when climate change and biodiversity actions are finally taken.
OTHER IMPACTS OF CLIMATE CHANGE AND BIODIVERSITY LOSS
Other impacts of climate change and biodiversity loss include their potential impact (directly and indirectly) on:
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KEY RESOURCES How climate change and biodiversity loss could affect countries
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THE IMPACT OF CLIMATE CHANGE AND BIODIVERSITY LOSS ON THE FINANCIAL SECTOR
Supervisors need to determine the potential impacts of climate change and biodiversity loss on the financial sector, and hence on their objectives for the safety and soundness of the financial institutions they supervise, financial stability, consumer and investor protection, and financial inclusion.
The main impacts of climate and biodiversity-related risks on the financial sector are likely to be on:
The relevance of each of these impacts to a supervisory authority will depend in part on the mandate and objectives of each supervisory authority, and in part on the prospective nature and magnitude of each of these impacts.
Many supervisory authorities have found it useful to discuss these possible impacts with supervised firms and other stakeholders, individually and/or collectively, and to use this to build a picture of how climate and biodiversity-related risks might affect financial institutions, financial stability and users of financial products and services.
FINANCIAL POSITION OF SUPERVISED FIRMS
Financial institutions – individually or collectively – could make large losses, or even fail, because of the impact of climate and biodiversity-related risks, including the various physical and transition risks set out above. This could also threaten financial stability where individual institutions are systemically significant, or where failures are widespread.
Financial institutions may also face reputational and litigation risks. For example, banks’ lending activities, and the assets held by banks, insurers, investment funds and pension funds, may be incompatible with the preferences of their owners and customers; or they may be incompatible with meeting national climate change and biodiversity targets.
Supervisory authorities - and supervised firms – therefore need to consider and assess the linkages between the physical, transitional and reputational/litigation risks and their impact on individual financial institutions and on the financial sector more generally.
One approach to this is to consider how these risks feed through to more granular risk types, including credit, liquidity, insurance, market, operational resilience, and legal/reputational risks; and then to assess the potential impact of each of these granular risks on the financial positions of supervised firms. For a financial supervisor this would also be a good way to incorporate climate and biodiversity- related risks into a risk-based approach to prudential supervision.
For example, physical, transitional and reputational/litigation climate and biodiversity-related risks could:
Climate and biodiversity-related risk drivers will have different impacts across countries, across regions, across financial sectors, and across individual supervised firms. For example, physical risks may be the most important drivers of the credit and insurance risks inherent in lending to and in insuring small farmers; while transition risks may be the most important drivers of the market risk inherent in holding securities issued by fossil fuel producers and by companies in high hydrocarbon use sectors such as mining and cement.
Time horizons may also be important here – immediate government actions or technological advances to limit physical risks could generate short and medium-term transition risks; but inadequate government actions might minimise near term transition risks while increasing physical risks over the medium and long term.
Scenario analysis and stress testing are useful tools here for both supervisory authorities and supervised firms. Alternative scenarios for climate change and biodiversity loss will be associated with different levels and types of physical and transition risks, which in turn will feed through in different ways to sectors within the economy, to the macroeconomy, and (directly and indirectly) to financial institutions.
Climate and biodiversity-related scenario analysis and stress testing is not straightforward. Specifying high-level climate pathways is reasonably simple, for example the use of climate change pathways based on (i) meeting national and international targets for climate change on schedule or ahead of schedule, and (ii) a continuation of recent climate change without any actions to limit or reduce these changes.
However, it is more difficult to specify biodiversity pathways, in part because there is no single metric (such as temperature changes or greenhouse gas emissions) to describe each pathway.
Instead, hypothetical biodiversity loss narratives can be created, with an emphasis on the loss of specific habitats or species relevant to an individual country or region. These narratives could then be combined with climate pathways, which might also enable consideration of the interactions between climate change and biodiversity loss.
These climate and biodiversity pathways then need to be translated into their likely impact on countries, sectors and financial institutions. This is difficult, not least because of:
One response to these difficulties has been to focus – at least initially – on the likely impacts under each climate pathway or biodiversity narrative at the industry, sector or regional level, identifying which industries, sectors or regions in a country might be most affected by different types of physical and transition risks, and the possible magnitude of these impacts. These impacts can then be mapped against the credit, insurance and market exposures of financial institutions. This does not avoid the difficulties and limitations listed above, but it can provide a useful starting point.
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KEY RESOURCES Financial position of supervised firms
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FINANCIAL STABILITY
Supervisors (and other authorities with responsibilities for financial stability) need to assess the potential impact that climate and biodiversity-related risks could have on financial stability. Scenario analysis and stress testing will again be useful tools here.
Climate and biodiversity-related risks to financial stability risks include: