Climate change affects financial stability
Published: 25 January 2023
Climate change and the transition to a sustainable economy also create risks that could threaten financial stability. The physical risks can include damage to households, businesses and infrastructure. A delayed or protracted climate transition increases the risk of large price movements and uncertainty on the financial markets.
The European Central Bank (ECB) and the European Systemic Risk Board (ESRB) presented a report in 2022 on the systemic risks that could result from climate change. The report concluded that the interconnectedness of the financial system increases the likelihood that climate risks will be amplified and propagated within the system. For example, if the price of emission allowances rises rapidly and sharply, the costs for companies with high emissions increase. This can lead to investors quickly trying to sell off their holdings in these companies in a so-called "fire sale". This, in turn, can cause sharp price movements in financial markets. Even before the price of emission allowances rises, investors with carbon-heavy investment portfolios may be perceived as uncertain. This could reduce confidence in these investors and contribute to instability in financial markets. See ESRB, (2022) The macroprudential challenge of climate change.
To reduce financial risks, it is therefore important that agents across the entire financial system take responsibility for identifying, measuring, assessing and managing climate-related risks in their operations to the greatest extent possible.
The banks need to manage their exposure to climate risk
Banks are a central part of the Riksbank’s stability analysis because they play an important role in the financial system. Banks are exposed to climate-related risks in a number of ways, most notably through the credit they provide to companies in industries that either affect, or are affected by, climate change. This lending is directly exposed to transition risks, as the cost for companies in these sectors to adapt their operations can be high.
In April 2022, the Riksbank and Finansinspektionen published a study of the transition risks in the banks’ loan portfolios, based on the PACTA methodology. Finansinspektionen, Sveriges Riksbank (2022), “Transition risks in the banks’ loan portfolios - an application of Pacta”, joint report by Finansinspektionen and Sveriges Riksbank. PACTA (Paris Agreement Capital Transition Assessment) is used to analyse how well companies meet climate targets in different climate scenarios over a five-year period. Although the study covers only a small part of bank lending, about SEK 80 billion, corresponding to about 3 per cent of total bank lending to non-financial corporations, “Non-financial corporations” refers to corporations outside the financial sector. it can be concluded that banks are exposed to transition risks. More than half of the money goes to companies that are currently engaged in activities that are directly harmful to the environment and that, moreover, will not meet the climate targets in five years’ time.
The results can be used to support the analysis of transition risks associated with bank lending to non-financial corporations. The Riksbank has previously noted that both companies and banks need to improve their sustainability reporting so that the climate risks they are exposed to can be better analysed and managed. The Riksbank considers that the Swedish banks should already report their exposures to climate risks in accordance with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). The banks themselves need to understand how climate risks affect the risks of loan losses and to adjust their lending accordingly. Chapter 3 describes how the Riksbank is working to develop its analysis of these risks. A necessary step towards better management of climate risks is better data to describe them.
Managing climate-related risks requires better climate-related data
In order for participants in the financial system to assess and manage climate-related risks, they need access to reliable climate-related data. In the absence of such data or if data is inadequate, investors can easily get a misleading picture of the exposure of different companies to climate-related risks. This can lead them to invest in unsustainable companies, believing them to be sustainable, and thus expose themselves to higher risks than desired. It also hampers climate transition, increasing climate risks in the long run. Uniform and standardised frameworks must therefore be developed to increase the transparency of climate-related data.
Internationally harmonised requirements exist for financial reporting, but are still lacking for sustainability reporting. This makes it difficult to compare and use sustainability reports. See N. Frykström (2022) Transparency for efficiency and financial stability, Economic Commentary, no. 11, Sveriges Riksbank. On the other hand, extensive work is under way to create such standards, both in the EU and globally. Table 1 presents ongoing projects on sustainability and climate transparency in financial companies.
|TCFD||NFRD||CSRD (ESRS)||EU pillar 3||IFRS sustainabilityreporting|
|Quality assurance (audit)||No||No||Yes||No||No|
|Implementation||2,017||2,014||Will take effect 1 Jan 2024 with first reporting in 2025.||Has applied since mid-2022 with first reporting in 2023.||Standard is expected to be ready in early 2023. Unclear when implementation will take place in countries but voluntary use is supported.|
|Jurisdiction||Global||EU||EU||EU||Global, not the US|
European banks will need to disclose both physical and transition risks in a standardised format under Pillar 3 of the EU. To do this, they need reliable information from their customers. The current Non-Financial Reporting Directive (NFRD) requires certain major companies to report on environmental and social sustainability factors. Work is currently under way to replace the NFRD with the more far-reaching Corporate Sustainability Reporting Directive (CSRD), which also introduces harmonised disclosure standards (European Sustainability Reporting Standards or ESRS) to facilitate comparisons.  ESRS (European Sustainability Reporting Standards) are developed by EFRAG, the European Financial Reporting Advisory Group. The CSRD is scheduled to come into force on 1 January 2024, with the first reporting of sustainability information by major companies in 2025.
Greenwashing can be a stability risk
Greenwashing is a problem that arises precisely because of a lack of transparency. Many consumers and companies are demanding sustainable and green products. This can lead companies to market themselves, or some of their products, as more environmentally friendly than they really are. For example, a fund may be marketed as environmentally friendly but not invest in green companies to any significant extent. This is a form of greenwashing.
Greenwashing is problematic from a financial stability perspective. Capital that would otherwise have been invested in companies actively working on the climate transition is instead invested in companies that, in the worst case, are hampering the transition, which in turn can increase the risk of a disorderly transition. In the long run green washing can affect the confidence in green financial products and the role of the financial sector in the transition to a fossil-free society. To tackle this problem, clear rules are needed for how companies can classify and market products, and there must be effective monitoring and supervision of the rules.
Swedish mutual funds can do more to contribute to the climate transition
In Sweden, several investment management companies have joined the Net Zero Asset Managers Initiative. A study by the Riksbank shows that, on average, over the period 2019-2021, equity mutual funds that have joined this initiative do not have a lower carbon footprint than others. However, the results suggest that they are more likely to invest in a way that leads to lower carbon emissions in the long run.
Importantly, these mutual funds have not reduced their exposure to the most polluting companies in their portfolios. There may be two main explanations for this:
- the funds are keeping the most polluting equities in their portfolios because they consider the companies issuing them to be working sufficiently on their green transitions
- the funds are not greening their portfolios quickly and effectively enough.
The latter explanation is more problematic, both for the climate transition and for the financial system. To better understand why the carbon footprint is not declining in the funds that have joined the initiative, there is a need for better structured, more transparent and more easily verifiable information that allows for proper monitoring. C. Cella (2022), Fifty shades of green: the colour of Swedish equity funds, Staff Memo, September, Sveriges Riksbank.