Transcript provided by Kensho. 

Lindsey Hall: Hi. I'm Lindsey Hall, Head of Thought Leadership at S&P Global Sustainable1.

Esther Whieldon: And I'm Esther Whieldon, a senior writer on the Sustainable1 Thought Leadership team.

Lindsey Hall: Welcome to ESG Insider, a podcast hosted by S&P Global, where we explore environmental, social and governance issues that are shaping investor activity and company strategy. 

We're starting a busy season in terms of sustainability events in the run-up to COP27, and climate is front and center of discussions. This past week, we've been right in the thick of Climate Week NYC, looking at the rapidly developing climate landscape, and we'll be bringing you interviews and key takeaways from those events in upcoming episodes.

Today, we're looking at the regulatory landscape and some of the recent climate developments out of Europe. As urgency to address climate change intensifies, financial regulators and supervisors are taking an increasing interest in climate change and the impact it's having on the financial system and the economy at large.

Esther Whieldon: For example, at the beginning of September 2022, the Network for Greening the Financial System published a new set of climate scenarios designed to guide central banks in managing climate risks. The NGFS is a group of central banks working together on climate change.

These new climate scenarios include commitments made at the UN climate conference, COP26, last year and include NGFS' first projections of potential losses to the economy of more than 6% by 2050 from extreme weather events with that number rising to 18% by the end of the century. In a recent episode of this podcast, we spoke to NGFS Chair, Ravi Menon, about the group's work and will include a link to that interview in our show notes.

Lindsey Hall: In Europe, the summer months were busy ones for financial regulators as it relates to climate. In July 2022, the European Central Bank announced plans to incorporate climate change into its monetary policy. Later that month, they announced the results of a climate stress test of the European banking sector.

To find out more about what central banks are doing in the run-up to COP 27, we're turning to Irene Monasterolo, who's Professor of Climate Finance at French business school, EDHEC. The interview you're going to hear is conducted by our colleague, Jennifer Laidlaw, a senior writer on the S&P Global Sustainable1 Thought Leadership team. And as you'll hear, Jen asks Irene, what kind of announcements can we expect in the coming weeks and during COP27?

Irene Monasterolo: There has been a publication of the third version of the Network for Greening the Financial System climate scenarios. So this has been a big event already in preparation of COP27, meaning that both investors, central banks and financial supervisors will use these new scenarios in their next climate stress test exercises.

However, what I would really like to hear more is about not only climate finance in terms of mitigation, but also climate finance in terms of adaptation. This has been so far out of the radar and actually attracted still limited attention. But investing in building resilience to climate change is complementary to investing in mitigation.

Jennifer Laidlaw: So more needs to be done now with adaptation as far as financing goes?

Irene Monasterolo: Absolutely, yes. So far, we had most of the discussion emerged and be carried out for low income and emerging economies. In particular, there was a discussion about debt for climate swaps and so on. But even in industrialized countries, but even within the European Union, governments have a large need to invest in adaptation.

And yet, we know that starting conditions for governments to invest and to access capital, differ a lot. And in particular, governments that have limited fiscal space and yet high -- public high stock or public debt would find it hard, and cost there to us as the finance need to invest in adaptation.

Jennifer Laidlaw: Yes. All right. And do you think that's something that people will discuss at COP? And do you think it's maybe become more urgent just given the fact that we had very extreme like weather conditions over Europe, this summer, ranging from heat waves to flooding to wildfires in certain parts of Europe. Do you think that will kind of like speed up the urgency as we move towards discussions at COP?

Irene Monasterolo: I really hope so. And wherever I know that with colleagues, we will have a session on this topic, but I think that, in particular, development finance institutions and international development banks would bring this topic upfront. I would also expect central banks and financial regulators to move forward on this topic. I think that another important point to cover and that start to be discussed yet at the level of theory, but in practice and in modeling practice, in particular, has not received enough attention yet is the assessment of the double materiality of climate risk? What does it mean? It means that the relation between climate and the economy of finance is characterized by 2 feedback loops as identified already by the European Commission in 2019. So on the one hand, we have the impact of climate change and the transition on the economy and from there to finance. And this feedback has been more analyzed in the literature in particularly in the last decade.

However, there is also no positive feedback, which is what happens when investors look at the potential impacts of scenarios of physical and transition risk, decide to adjust their investment -- the financial risk assessment and the investment criteria, for instance, cost of capital for firms by -- cost of capital that banks provide to firms via their lending. And how this, in turn, affects the investment decision of firms in higher low-carbon goods and all these in turn, affect the realization of the same scenarios.

It's really important to grasp both feedback loops in the same methodological framework when you then want on the one end to assess risk, but also the opportunities. And in particular, when we want to analyze under which conditions in terms of design, policies, green financial policies and initiatives could actually affect investors' response to climate change and their internalization and support or hinder the transition.

Jennifer Laidlaw: Sticking with the topic of green finance policies, I asked Irene about the importance of the European Central Bank's new climate policies. For a bit of background from October 2022, the ECB will favor low carbon issuers when it purchases corporate bonds. But here's Irene to explain more.

You'll hear her talking about Scope 1. Those are direct emissions from operations. And Scope 2, those are indirect emissions primarily derived from purchased energy. She also mentions Scope 3, where the emissions that occur and down a company's supply chain as well as when customers use the company's products.

Irene Monasterolo: There are at least 3 reasons why the ECB announcement about green monetary policy and green asset purchase in particular is important. The first is that it finally puts an end to the discussion about whether climate change matters for central bank monetary policy and asset purchase. They have been indeed growing debate about central bank's primary mandate, which is about price and price stability and financial stability.

In particular, for the European Central Bank, it has the mandate to maintain inflation at around 2%. With this move, the European Central Bank makes it clear that climate change pertains also the ECB mandate. And that's particularly important in terms of market signaling.

Just to recap, the ECB proposed tilting to increase the purchase of assets issued by firms that have a better climate performance in comparison to those with worst climate performance and how the climate performance is considered is about the carbon footprint, that's based on GHG emissions, greenhouse gas emission disclosure, of firms and their alignment plans.

So this is the first reason. And the second reason is the firepower that the European Central Bank had so far with their -- with its asset purchase program if we consider even just the more recent pandemic emergency purchase program, this reached over EUR 1 trillion in particular, EUR 1,690,000. So announcing greening of asset purchase in this market condition could be relevant in terms of magnitude.

And third, it's important because it emerged in a period characterized by high geopolitical and energy crisis. And thus, with this move, the European Central Bank indirectly signals also governments about the importance to foster the low carbon transition while several or most of European member states are turning back to fossil fuels.

Jennifer Laidlaw: I also asked Irene how this could encourage companies and financial institutions to be more transparent about their carbon emissions and reduce them over time.

Irene Monasterolo: Well, the point that the announcement of greening asset purchase is important should not hide the fact that the devil in the detail. And the fact that the tilting proposed by the European Central Bank is based on reported emissions and carbon footprint firms. Well, this could actually even hinder further decarbonization.

Why? Because research has shown GHG emissions disclosure and carbon footprint are actually poor proxy of firms’ commitment and alignment to the transition. And why? Because for instance -- well, first of all, it's well known that there are issues with standardization and comparability of GHG emissions disclosure.

And then there is another important point, which is what do emission tell us about how well a company is preparing for the transition, so in terms of impact, but also exposure to transition risk. And the result is that data has very little. For instance, in a recent article that we published in general portfolio management, we showed that 2 companies within the automotive sector that have very similar Scope 1 and Scope 2 emissions reporting., actually, they differ in terms of Scope 3 reporting by 30 times. And this is only due to the fact that one big company follows the standards for Scope 2 reporting, the other company does not. And in this condition, actually, if the ECB would just follow the reporting by companies of their emissions, in this case, Scope 3, it will end up buying more bonds of the company that just reported less well.

Jennifer Laidlaw: I also spoke to Danae Kyriakopoulou, a Senior Policy Fellow at London School of Economics' Grantham Research Institute on Climate Change and the Environment. She said the corporate bond purchases, market change in the ECB's thinking.

Danae Kyriakopoulou: It's been a debate that has been building up over the recent past. There is the principle of market neutrality that governs the ECB's corporate bond purchases. But the ECB has been increasingly recognizing that there is a carbon bias in this market neutrality principle, which means that it's unconventional asset purchases, the corporate bond purchases are actually not market neutral because there are mispriced risks.

Climate change is market failure. It is an environmental externality and prices do not fully reflect the true effect. So there is this mispricing of risk, which is why you need policies to adjust that. This was a very important move by the ECB.

Jennifer Laidlaw: Now, the ECB has decided against an exclusion approach, so not excluding high-emitting companies. And given that, what incentive does that actually give to large polluting firms to actually change their ways?

Danae Kyriakopoulou: Yes. This is a very interesting question when you compare the types of strategies that central banks and other owners of portfolios have and exclusions can be effective, but not in all cases because you also need to help the firm's transition. And excluding companies may, in some cases, lead to these types of companies end up in the wrong hands, in asset owners that do not have as strong sustainability commitments and continue financing them.

And in the case of the ECB, when you talk about the monetary policy portfolio, it's much harder to implement exclusions compared to, for example, its own funds or its pension fund portfolio where there may be more flexibility. And that is true of other central banks as well. So we've seen pension funds more widely in other public investors exclude certain sectors from their portfolios.

This is becoming more common as a last resort kind of policy where engagement or supporting the transition of these sectors is not working. And we are seeing that this is now more and more possible. Actually at COP26 in Glasgow, there was a huge effort to advance more the agenda of transition plans in the financial sector to be able to tell apart companies that may have the same carbon footprint in the present, but where one may have a more credible plan to transition in the future and so may be more worthy of continuing to be funded.

Jennifer Laidlaw: The ECB is also planning to amend its collateral framework by limiting the share of assets that corporates with a high carbon footprint can pledge as collateral when borrowing funds from the central bank. How important is that particular move?

Danae Kyriakopoulou: I would go as far as arguing that this new collateral framework is the most ambitious we have now in the central banking world. What the Eurosystem said is that it will, as you said, limit the share of assets issued by those entities with high carbon footprint.

And this effectively makes dirty credit more expensive, and it penalizes the financing of these dirty activities. So it's really a very powerful move and it's motivated by the need to reduce this climate-related financial risks in the credit operations of the Eurosystem.

Jennifer Laidlaw: I also ask Danae about other tools central banks can use to protect the economy from climate change risks.

Danae Kyriakopoulou: They can also have green lending programs, for example. Then as supervisors, they are responsible for the banking system, for the financial system. So they can also look to deploy tools that encourage the sector to address climate-related risks. So here, we may see climate stress tests, for example, that are becoming more mainstream. Or in prudential policies, some central banks are considering adjusting their capital requirements and tilting those based on climate considerations. And then in terms of leading by example, what they do as institutions themselves, they can also become more energy efficient in their buildings and their operations, but also in the way that they manage the reserves and the portfolios that they hold.

Jennifer Laidlaw: And you mentioned the climate stress tests that central banks have been conducting. I mean how useful is that for finding out the climate risks within the economy?

Danae Kyriakopoulou: Some central banks have begun implementing climate stress tests. They have been setting climate scenarios and looking at how different banks would perform under those scenarios. They are very useful as a process because they lead to the creation of information, of better understanding of how exposed the banking sector is. But so far, we haven't seen central banks take action.

It's been more at the level of gathering the information and encouraging the institutions to take more measures and to understand better the risks that they are facing. In future, we may see and there have been some hints that we may also see action as a result of stress test. But in comparison, for example, to the conventional stress tests and exposure to different macroeconomic scenarios, we do not see action from central banks following the results of the stress tests.

Jennifer Laidlaw: There seems to be a general consensus certainly in the results of stress tests that I have seen that banks really need to step up their efforts to take into a current climate change. Is that a little bit worrying?

Danae Kyriakopoulou: Yes, there is a climate change and its impact is generally very worrying, and we are seeing this, the more data we gather, how urgent action -- the need for action is and how unprepared we are if we do not step up action in time. And that is certainly true also of the financial system and the banking system. It is relatively recent that we have seen the financial sector engage seriously with this and stress tests definitely help in that process.

Jennifer Laidlaw: Now we touched upon prudential regulation looking at perhaps increasing capital for banks in the future given the results of climate stress tests. I mean, when would you expect like central bank's regulators to maybe take some action on that? And what kind of action might you expect?

Danae Kyriakopoulou: Yes. So the options there are for central banks to introduce a so-called green-supporting factor that lowers the capital requirements for lending to sustainable activities or a brown-penalizing factor that increases the capital requirements to dirty activities.

So far, we haven't seen a huge amount of enthusiasm from the central banking community for a green-supporting factor. There is the argument that green does not necessarily mean risk-free in other elements. And so central banks have been more cautious about this. But we are seeing some central banks, let's say, tip their toes into this area, for example, the People's Bank of China or the Hungarian Central Bank.

Jennifer Laidlaw: Increasing capital requirements for banks who lend to polluting sectors or offering capital discounts to lenders who finance green projects has been a hot topic of discussion among European lenders. I ask Irene about the possibility of penalizing banks with higher capital charges for lending to high emitters.

Irene Monasterolo: This is the big elephant in the room because so far, for instance, in the European Union, we had -- there was the publication of the taxonomy, European taxonomy of sustainable activities, which should at least at the beginning, help to identify which activity could be defined as sustainable in the economy, but we don't have yet a classification of activities that could become carbon-stranded assets.

And yet, we know that these activities are the activities that could bring largest risk, both to the economy and finance because on the one hand, they could -- if we introduced -- we have a disorderly low carbon transition. So if the carbon tax is introduced in a late and sudden way, which is mostly the direction where we are going to, these activities related to directly or indirectly to fossil fuels will lose value in the economy and with implications for instance, on employment, first profitability. But then also since these activities and these firms have issued securities like stocks, bonds or have loans with banks, then the loss in performance would translate also on the portfolio of the investors who are exposed to such firms. This is why it's fundamental to add a classification, potential carbon-stranded assets.

Jennifer Laidlaw: As climate change is taking an increasingly important role in monetary policy, I also spoke to Stanislas Jourdan, Executive Director of the Brussels-based nongovernmental organization, Positive Money Europe, where he leads advocacy campaigns and research on the ECB and monetary policy. I asked him what actions central banks might take in the future. You hear him talking about a TLTRO program, which stands for targeted longer-term refinancing operations, whereby the ECB offers long-term loans to banks at favorable costs.

Stanislas Jourdan: What the ECB has done so far with the decisions in a way, do not change a monetary policy system. The ECB is going to raise interest rates anyway regardless of this climate action plan. So I think at this point, it would be hard to agree that the climate agenda of the ECB is kind of dominating the monetary policy agenda or something like that.

Now in the future, this could change and perhaps for the best because if you think about the current energy price shock that is impacting the economy, we might have gas shortages this winter, that will provoke a recession. You also have an issue with high energy prices having an impact on households, on mortgage orders, people who have to pay back the mortgages and at the same time, are really struggling to pay their energy bill.

So at some point, you could have a domino effect on the mortgage repayment. If you start thinking about the fact that currently inflation is dominantly due to energy prices and not for a particular kind of monetary phenomenon of excessive demand versus shortage of supply, the current inflationary pressure is really due to fossil fuels actually and the reliance of Europe on Russian gas and the lack of domestic supply of green energy.

So if you think in those terms, then there could be a case for the European Central Bank to go one step further by taking measures such as a green TLTRO program or a lower interest rate for certain types of investments such as green energy and energy efficiency, for example, energy-efficient buildings.

Because basically, if the ECB would support the European economy to lower its dependence on imported fossil fuel energy, which is volatile and very expensive right now, by improving the domestic supply of energy and by reducing the consumption of energy through energy efficiency, that would basically improve the inflation forecast.

So actually, what I just said in a nutshell is that greening the economy will become a condition for managing price stability in the future. And if that's the case, then yes, the ECB will have to go further in greening their monetary policy strategy.

Jennifer Laidlaw: How do you see things like climate stress tests that central banks have been conducted? How can that help in greening the economy?

Stanislas Jourdan: What the stress tests have shown is that there is a correlation between energy efficiency of buildings and the exposure, the credit risk on banks. And it's quite intuitive, actually. I mean, we know statistically that poorer households tend to have higher leverage on the mortgages, but also they tend to buy houses that are less energy performance.

And therefore, if you have an energy shock like we have now, an energy price shock, those particular households are going to be hit harder by energy prices because they have a poorly insulated home basically. And they are also going to be a bigger risk for the bank because they're more leveraged, so there could be bigger losses on the line.

So long story short, what this shows is that energy efficiency should be a key concern of banks when it comes to their mortgage policy. And I think the only way that banks can really protect themselves from future risks due to energy efficiency would be to help the consumers renovate actually because that would actually remove the risk that I just talked about.

If people have well-insulated homes, their energy bills go down, and therefore, they will be more solvent and more likely to be able to pay the mortgages. So it will be key for banks to have a business strategy to help the consumers renovate as soon as possible in order not just to help the planet but also to help themselves, I would say, to prevent this kind of insolvency risk.

Jennifer Laidlaw: Yes. So they could propose things like low interest rate loans for renovation and other current products.

Stanislas Jourdan: Absolutely. I mean, loans for renovation are critical. Yes, what some people call green mortgages that are mortgages that includes the purchase of a home, but also the cost for renovating the home. At the same time, these type of products, I think, every bank should develop them urgently.

And not just develop them, but proactively analyzing the mortgage portfolio and getting in touch with the consumers that they think are more likely to be affected by the energy price shock.

Lindsey Hall: So Jen, it sounds like central banks are poised to take action on addressing climate change risks over both the shorter and longer term, whether that's via monetary policy or through tools like climate stress testing.

Jennifer Laidlaw: Yes, indeed, and climate stress tests will be key to the direction central banks take. These are very much learning exercises and will amass critical data and information.

Esther Whieldon: Yes. And in the near term, it will be interesting to see what central banks have to say at COP27 and what solutions they can offer for climate change. So Jen, please keep us updated on any developments.

Jennifer Laidlaw: I certainly will.

Lindsey Hall: Thanks so much for listening to this episode of ESG Insider. And a special thanks to our producer, Kyle Cangelosi. Please be sure to subscribe to our podcast and sign up for our weekly newsletter, ESG Insider. See you next time.

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