 Climate change has finally reached the mainstream debate and is hitting the screen of everyone who is interested in the future and has policy responsibilities. Welcome to the European Central Bank podcast, bringing you insights into the world of economics and central banking. My name is Michael Steen and in today's episode we're talking about climate change. You just heard ECB President Christine Lagarde speaking at the European Parliament in Brussels in December 2019. On climate change we have as central bank to explore in all the dimensions that we develop, implement and orchestrate how climate change has or doesn't have an impact and how we can be effective in participating in the fight against climate change. Now this does not turn us into having as mandate number one the fight against climate change. This is a matter where clearly governments, policymakers have the key role to play but it doesn't stop us from having to look into our operations and identifying how we can be effective. So how does a central bank fit into the climate debate? In this episode we want to take a snapshot looking at a few of the questions around climate change and the economy. I should say we don't yet have all the answers to these questions, especially regarding our role. The ECB has just launched a year long strategy review which will also touch on this topic but what we wanted to do today was outline some areas where we are already active and where more work might follow. So what can we do as a central bank to support green financing and where are our limits? So let's unpack that by speaking to three ECB colleagues who all look at different aspects of climate change. My first guest today is Fatima Pires from our financial stability department. Fatima, welcome to the podcast. Thank you. Hello everyone. Before we go into details, let's take a step back. How do we classify the different kinds of impact from climate change on the economy? Typically how we think about it is via to risk so physical risks and transition risks. Physical risks can take the form of severe events like the onset of sudden floods or landslides. It can also be acute physical risks like wildfires or heat waves but it can also be gradual change resulting from the longer term rise in global temperatures and here we have rising sea levels or droughts and this we call chronic risks. These types of risks can have an impact on the economy. One can be via you know it can damage infrastructure, private property so we have insurers that have for example discontinued policies in areas that are fire prone or prone to to floods and this of course impacts the costs of home ownership. Agriculture and crops can be devastated which of course can impact the prices of food. Second, it can disrupt economic activity, global supply chains, trade and this can create resource shortages, it can divert capital from more productive uses to replacement. It can also have an impact in terms of uncertainty about losses which also can reduce investment so this is all in the camp of what we typically coin physical risks. And then transition risk? Yeah so then there's also the transition risk which of course in shifting to a low carbon economy we also have to take actions and these actions can have certain effects on the economy like for example employing a carbon tax and there's also shifts that can come in terms of transition risk in terms of technological change or a sudden shift in consumer sentiment where all of a sudden you know let's say products that were always being bought all of a sudden stopped being bought and this of course can have an impact on industries but also on unemployment. Diesel cars come to mind there maybe? Possibly I think that's let's see how how let's say the industry is reacting to that but indeed that that is one of the risks and I think what is really important in terms of transition risks is that this is something we actually need to manage and it's important to take action now and to enact policies that are ambitious, they're effective but that also allow us to have this orderly transition. That's a pretty scary picture but shifting to us as a central bank what what do we look at? So let me first start by saying that the primary responsibility of of taking action to enact policy change is for governments. Nevertheless in the face of this major challenge for everyone and within our mandate we all have to play a role. So as a central bank and a supervisor more generally our mandates center on three key areas we have price stability, financial stability and the safety and soundness of financial institutions. In all these areas climate change has an impact. Okay so let's turn to your area of expertise what does climate change actually mean for financial stability? Let me first start by explaining how we define financial stability. Great that's a great way in yes. So financial stability is a condition in which the financial system you know composed of financial intermediaries, markets, market infrastructures is capable to withstand shocks and the unraveling of financial imbalances. So what does this mean exactly mean? So it means that we aim to reduce the likelihood of disruptions to the financial system that can be systemic or that can trigger a contraction of economic activity. This means we're looking at the extremes right? Exactly exactly and but we can think we think about climate change risk we actually see that there is this risk of financial stability given as I just spoke about you know the type of physical risk and transition risk and to give you a bit of an illustration of how climate change can have an impact on the economy and in terms of financial stability if we think about physical risks. So financial institutions for example they can be directly impacted by some of these natural catastrophes right? So we have the solvency of firms and households can deteriorate in case they are hit by climate disasters and this could also have consequences on banks resilience that have for example extended loans to these firms or households. So to say to an industry that suddenly doesn't actually have much of a market anymore because it's been affected by. Exactly and these and it can be affected by transition but also by natural catastrophes right? Additionally firms and banks themselves are also facing higher operational costs and risks so their activities can be directly impacted by these types of risks so they also need to be aware of those and you know need to be resilient enough maybe agile enough to manage those risks. So that's on the physical side on the transition risk side financial markets can be adversely affected by these sudden shifts as I mentioned not only due to policies but also to technology shifts you know or or to shifts in consumer sentiment and and that can also lead to certain risks that financial institutions need to manage more. So both types of risks physical and transition are a concern for us in terms of financial stability they can create shocks and disruptions that can lead to the financial system not being able to serve as households and businesses. Okay so what kind of tools do we have to spot these risks? You know there are steps that we are already taking but this is not an easy task because we are really facing formidable inadequacy of information. The foremost among the measurement gaps that we are currently grappling with is trying to understand the exposures of financial institutions to climate change related risks. To fill these gaps we have led a project team with the European Systemic Risk Board where together this project team is looking at two objectives so the first one they're developing and will implement a pilot monitoring framework for the climate related systemic risks in the EU financial sector. So this is going to include risk indicators and an exposure analysis so that is quite relevant. Just to jump in there is there is the problem there that the the companies themselves don't necessarily know or that we don't have the information that they have or both? We definitely need to to step up firms' disclosures and this is something really really essential and this kind of brings me to my to my second point of what this project team is focusing on it's finalizing also a pilot stress test which is separate from the European banking authorities EU wide stress test. This will investigate transition risks for bank solvency and their lending capacity and this will also look at you know the implications for the overall economy. This is expected to be finalized in the coming months. On the basis of what we have learned from this the ECB we are actually developing now more comprehensive climate risk stress testing framework and and then I can already say we expect to have the first the first results by the end of this year so we are going to to try and put together both physical and transition risks to understand how these can impact the resilience of the financial system. We will try to also understand a bit more the consequences of the potential policy actions and inaction again also related to the different timing and to also in this way try to identify you know which policy calibration and timing can minimize financial stability risks and I think this is something that we are are really very excited about of learning a bit more and yeah carrying out this this this stress test. This is quite a huge undertaking right because classically I suppose for financial stability you're looking at very classical sort of financial indicators what's happening with banks capital and share prices and things like that and suddenly we're bringing this whole new vocabulary around the climate and climate risks. Indeed it's really it's really a very big challenge and you know if we think about it the financial system of the future is going to look really different than what it is now and we need to understand what these seismic shifts are actually meaning for financial stability. They're quite important we need to incorporate more a longer term horizon which is something that up until now you know we've never thought of what is you know 20 years or you know we've tried to keep things at a more shorter term but now it's much more important to have this longer term horizon. It's also important to bring in you know climate scientists into let's say the realm of our humble economics profession. So a lot of what you're saying is talking about cooperation I mean you just mentioned bringing climate scientists to our humble economics profession some might debate how humble it is but leaving that aside and we've also had President Lagarde talking about the need for action a lot of this is actually the role for governments. So if we take all of that together and we sort of step back and look at the global level how does cooperation look there and you know what are we doing and what are others doing? Indeed climate change is is a complex global challenge and it requires a collective effort to address it. In Europe considerable progress has been made especially if we compare to other advanced economies. We have member states that have committed to make the EU carbon neutral by 2050. We have the European institutions that have taken up this challenge and each within their mandate have taken steps to make the EU ambitions a reality. Finance has a key role to play in terms of redirecting investments towards more sustainable economic activities. The ECB as I've already mentioned we have already taken steps to integrate climate change into our policies and we're looking further in how to further incorporate these sustainability considerations into our policies within our mandate. Central banks around the world are also doing what they can to address this truly global challenge. The ECB signed up to the network of central banks and supervisors for greening the financial system. Currently this group has around 55 members and 12 observers and it really brings together at one table central banks, supervisors and standard-setting bodies. The aim of this group is to contribute to the development of the environment and climate risk management in the financial sector but also to mobilize mainstream finance to support the transition towards a sustainable economy and here I would say you know watch this space. Okay thank you very much Fatima. Thank you and you know if I may I really like to a quote that I find that really summarizes this very well is a quote by Mark Carney as the the governor of Bank of England where he warned you know the task is large the window of opportunity is short and the stakes are existential. I think this is a call to action for all of us. Thank you. My next guest is Madeline Rousse from our market operations department. Madeline you and your team use about 20 billion euros every month buying bonds as part of the ECB's asset purchase program but where the climate change comes in is that critics often claim that we favor so-called brown or polluting assets from very carbon-intensive sectors so why don't we simply buy more green bonds? The ECB's asset purchase program or how we tend to call it APP consists out of four programs all of them buy different asset classes so the first one is the public sector purchase program or PSPP how we also call it and this one buys mostly debt issued by governments and super nationals agencies and regionals. Okay and that's the biggest part right? Correct. Okay that's roughly what of the whole? That's about 80 percent. Okay and then the other three are what? And the other three are what we tend to call the private sector programs that is the corporate sector purchase program the covered bonds purchase program and the asset back securities purchase program so the the latter three being the 20 percent that are remaining. And now if we're talking about green issues then if you the the the biggest part the 80 percent do governments issue green bonds? They do they do some some governments issued green bonds for example the Republic of France has issued the green bond the Netherlands as well and a few others and not too many though some countries intend or have mentioned their intention to to issue a green bond this year amongst those the German Republic for example but nevertheless the share is still quite small it's about one percent. And then when we're buying the private sector assets typically companies borrowing money from the capital markets and issuing bonds how does our green action look there what's that what share of I mean that's where we get a lot of criticism isn't it particularly around so-called polluters and brown assets. Yes but here I would need to take a step back all programs in the in the APP are subject to market neutrality so this means that when we implement the programs the purchases we intend to minimize distortions or impact on relative prices for the eligible bonds and also to avoid any unintended side effects on liquidity or market functioning. So we buy the market basically and that's a core principle but that also means that we must already hold a certain amount of green bonds in the portfolio that we bought so can you tell us how big is this green market and what is our share at the moment? So in the public sector purchase program in the PSPP we have been able to buy most of the bonds that are outstanding. The share of green bonds is slightly larger in in four corporate sectors. In November 2018 we published a box in the economic bulletin where we explained a bit more on the green bond market for corporates and at the time the outstanding amount was around 31 billion euros and our CSPP program had about 20 percent of that at the time. So about one in five of the green bonds that have been issued, but we're talking about the corporate sector here right, we've actually already bought. Yeah precisely. It must make us the biggest holder of these things presumably. Do you know that or? I would assume we're within the largest. Must be big. All right yeah. So green bonds are one piece that are that is part of climate change related considerations but a big piece of the puzzle is still missing and that is a standard classification for green securities and also for economic activities, the so-called taxonomy. That basically means just understanding or everyone agreeing that this particular investment or asset is green and this is why because at the moment it's a bit I guess confusing and there's different standards of time. Precisely. Yeah so at the moment we have to rely on whatever there is out in the market for some assets or for some entities there is information for some there is not the information is not always audited or third party verified. CO2 emissions data for example is most of the times outdated incomplete or simply not available at all. This taxonomy, what are the other benefits of that do you think? So the taxonomy does not only bring a categorization of green or non-green but it also provides reliable disclosure and transparency towards the general public and investors and that again helps investors channeling their assets into a low carbon economy. Okay so we focused a lot on the monetary policy operations and the portfolios there but there are two other sizable pots of money that the ECB manages our pension fund and what's called the ECB own funds. First of all actually can you just explain briefly what ECB own funds are? Yes exactly so the own funds is a portfolio that is a little over 20 billion euros in size and it consists of the paid in capital from the central banks to the European central bank with the objective to create the financial returns to help the ECB cover its expenses. Okay so that's the national central banks in the euro system when the ECB was founded paid in a certain amount into the ECB and that's the core of the own funds. Correct. Okay now we recently though announced some measures to make these more sustainable so could you tell us what we're doing there? Well the own funds portfolio is not used to implement monetary policy but it is still considered an investment portfolio and that's why it's somewhat more flexible to apply considerations related to climate change or a sustainable finance to that portfolio. At the moment we're investigating how to do that one of the options that we are considering is increasing the share of green bonds in that portfolio which would also help to finance green projects and reduce our carbon footprint. And for the pension fund? And the pension funds is the more interesting portfolio in that respect because its holdings are more diversified and they cover a broad range of assets there we have more flexibility in terms of climate change and sustainable finance. So the possibilities to integrate climate related considerations are much larger and we have a threefold approach. The first one is that we have selected our investment managers to be signatories of the United Nations principles for responsible investing and this means that the investment managers have to take environmental, social and governments considerations into their voting policies whenever they vote on our behalf in the annual assemblies of the companies that we own. So that is one. The second one is that we have implemented a selective exclusion list and the third layer that our president has recently announced in the press conference is that we have decided to change our equity benchmarks to the low carbon versions. So by that we will be able to reduce our carbon footprint by about 50% without increasing the risk of the portfolio. Madeline, thank you very much. Thank you. Another key aspect when looking at how climate affects the economy is the role of banks. This brings me to our next guest Patrick Amis. Patrick leads one of our banking supervision departments and oversees the work related to climate change from a banking supervision perspective. Patrick, welcome to the podcast. Thank you very much, Michael. Before going into your work on climate change as a supervisor, what is the role of banks in this debate? I think banks and the financial sector in general will have a very crucial role to play in financing the transition to a new carbon neutral economy. We need to keep in mind that moving to a greener economy will require a massive and sustained investment effort. It has been estimated that around 180 billion additional investment per year would be needed until 2030 to meet the Paris Agreement's target. So it's absolutely massive and of course banks will have to be at the forefront of financing this either directly via lending or through well functioning financial markets that will be able to channel money towards green investments. Concretely, what does that actually mean for banks? I mean, do they need to change their whole business models to adapt to this? Maybe let me first clarify a very important point concerning the role of supervisors in this topic. It is not in our mandate as supervisors to direct or mandate the business models of banks. They have to choose their own business model. What we have to make sure of is that they have proper risk management policies and procedures in place and that they incorporate well enough climate risks and climate transition in their business models. So I think one thing you do when you're looking at banks and their business models is you classify the different kinds of risks into big areas. Can you just explain that for us? The banks have to finance the transition to a greener economy. So from that perspective this is an opportunity for the banking system. But climate change is also a risk and of course as supervisors we tend to look at risks first. And in terms of climate risk, we traditionally make a distinction between the so-called physical risks and the so-called transition risks. So physical risks in a nutshell is what you would picture when you think about climate change and climate risk. And this is basically extreme weather events. Floods, draws and of course these risks may have an impact on the banks themselves because they are located in geographies that would be subject to extreme weather events. But also that would most importantly impact the customers of the banks. The second source of risk that we call transition risk is those risks stemming from the fact that a big part of the customer base of the banks will have to adapt its own business model to climate change and the transition. And if I take the example of carbon intensive or energy intensive industries or economic sectors, they will have to adapt and this could in turn create losses in in the banks activities either through changes in valuations of assets or because their customers would enter into difficulties in this transition process. So banks need to be mindful of both types of risks and of course I would just add that there is another type of risk that we see being present in both physical and transition which is liability risk. So the fact that banks might have to provide compensations for damages stemming from operations they currently finance. I mean is it the case then that in some banks they might look at either the physical or the transition risk and not place enough weight on the other or I mean would you typically see in the way they approach it? What we see typically is that banks when they start working on this are mostly looking at physical risks and they have later on to move towards transition risk analysis. An example of that might be say a big successful traditional car maker that hasn't adapted to say electric vehicles or something. Exactly. Okay so we've learned about physical and transitional risks that emerge from climate change. I mean how do you help banks prepare for these? So concretely what do we do? We as a first step we make sure that banks will incorporate climate risk into their risk management policies procedures and practices into their governance arrangements the highest level of the banks about climate risks and climate change making sure that they incorporate this into their pricing policies very importantly and finally making sure that they set aside appropriate capital against the risks stemming from their operations incorporating climate risks. I see. And we are currently working on a set of expectations towards banks in that respect. The second step will be to start submitting banks to stress testing incorporating climate risk and we are working on this together with our colleagues in the European Banking Authority and the third step will be to start considering additional capital need that we should impose potentially on banks where we would feel that banks are not adequately prepared but maybe you can just explain a bit more on this this this capital question and how that interacts with a green agenda. We have currently an ongoing debate as to whether banks would be authorized to set aside less capital for green activity and this confronts us was a number of challenges. The first one is what is green if as a bank I am financing a coal plant and I'm providing financing to improve the energy efficiency of that coal plant is this green. This is a very complex debate and currently the European Commission is working on a so-called taxonomy of green assets to help banks and capital markets and the public in general navigate their way so it's very complex question. This is how we can say this this this particular activity or investment is is green and this one maybe less. Absolutely. The second challenge we have is how can we demonstrate that a green asset is effectively safer than a non-green or brown asset. We are lacking data to evidence this because we want to make sure as supervisors that the capital requirements of banks remain risk based. So now I think another very important question is transparency so we think supervisors we think that banks should be more transparent I guess about the assets they have but can you talk about that a bit and how should that proceed. As you know we are committed to increasing the transparency and readability of our action and we surveyed recently a number of banks to understand whether their disclosures currently were at par with these international standards and we found the need for decisive progress and that also will be part of the set of expectations we will soon provide towards banks. Yeah it's a complex element because again we need to understand and banks need to understand what are the climate risks in their portfolios and very often they do not have simply the adequate information for this so they need to build that information in-house before being able to disclose but we continue to believe and we are convinced that market discipline will create strong incentives for banks vis-à-vis the public in general to get a better understanding of the climate related risks in their financial assets. Okay so just explain that what's the market discipline element here how does that work. The more transparent you are the more visible your actions are and this is what we want to get from banks when they make announcements with respect to transition it is important that the public at large can understand what this is about. We touched earlier on international cooperation as well and specifically this network for greening the financial system that we at the ECB are part of what does that look like from a banking supervision perspective. I would say that central banks and supervisors have really taken the lead in bringing the climate risk and climate change topic into the financial system discussions and we are very proud of that and we are very proud of participating in that endeavor. It's really precious to be able to confront views and questions and also to pull knowledge across central banks and supervisors all over the world so it's a very powerful driver of change in the financial system. What has already resulted from this cooperation? The NGFS is putting together good practices for supervisors and providing input as well to the debate that we already mentioned on risk differentials between green and brown assets. Patrick thank you very much for joining us on the podcast. You're most welcome. Thank you. This brings us to the end of this episode. I want to thank Fatima Piresh, Madeline Rose and Patrick Amis for taking part. As I mentioned at the top of the show there are still plenty of open questions about how the ECB plays its role in fighting climate change and one of them is filling the knowledge gap. A recent study showed that of 77,000 articles published in top economic journals fewer than 60 of them have been on climate change. Now we're linked to some of the publications by the ECB in the show notes as well as other related information and we'd love to hear your feedback and thoughts for future episodes via social media. You can also use direct messages and comments. You've been listening to the European Central Bank podcast with Michael Steen. If you like what you've heard please subscribe and leave us a review. Until next time, thanks for listening.