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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.

Central banks are responsible for ensuring the stability of financial systems and economies. And, increasingly, that means stepping up their action on climate change because they believe climate could have a detrimental impact on financial institutions.

Over the past few years, central banks have been playing a key role in measuring how banks insurers and the whole economy might be affected by different climate scenarios, from the best case to the worst. And in some cases, central banks are conducting climate stress test to measure bank's exposure to potential stranded assets.

We'll include a link in our show notes to the episode of this podcast, where we explored climate stress tests by France's central bank.

Esther Whieldon: Central banks are also working together to find the best ways of addressing climate change risk. In 2017, a group of 8 central banks and supervisors, including the Bank of France and the Bank of Mexico, banded together to create the Network for Greening the Financial System, or the NGFS. Membership has grown since then. As of June 2022, it included 116 members and 19 observers spanning the globe, including central banks in Canada, Brazil and Japan, to name a few.

Now in the past five years, NGFS has published guides for central banks on how to disclose their own climate risks, but it has also set out different climate scenarios to help financial institutions assess their future financial risk.

To learn more about this collaborative work central banks are doing, we'll turn to our regular contributor, Jennifer Laidlaw, a member of the Thought Leadership Team at S&P Global Sustainable1 and our resident expert on sustainability policy and regulation.

Jen, welcome back. Tell me who did you speak to?

Jennifer Laidlaw: For this episode, I got to interview Ravi Menon, who took over the chairmanship of the NGFS earlier this year. Ravi is also Managing Director of the Monetary Authority of Singapore, which is a central bank of Singapore. I started by asking him what role central banks were playing in addressing climate change.

Before we dive into the interview, just a quick heads-up. You'll hear him talking about taxonomies. That's a kind of classification system of sustainable activities.

Ravi Menon: The challenge of climate change is so pervasive, you really need a whole-of-nation, whole-of-society response. And central banks, being a major part of that ecosystem, have an important role to play. But it is not a primary role. It can't be the key needle mover. It needs to work together with the rest of the government, the financial industry and other stakeholders in this effort. Where I think central banks can make a focused difference; and I include regulators in this space, is to inject supervisory practices with respect to managing climate risks.

We need to address the risks that climate and broader environmental factors pose for financial stability and inject that in our supervisory process, which is a key focus of the NGFS. And when we do that, that will start to shift behavior among the financial institutions.

We also focus quite a bit on designing climate scenarios, actionable climate scenarios, because you can't forecast how this is going to pan out in the future. So we have to think in terms of scenarios and make sure that financial institutions are cognizant of these alternative pathways, and they have strategies and balance sheets that are resilient against different pathways.

We're also beginning to look at the implications of climate change for monetary policy. Very early stages yet, I think. And of course, we have another work stream that is looking at providing guidance for central banks on their own net-zero transition.

Central banks are, of course, not major emitters of carbon, but I think they can set an example with respect to their own operations, their own disclosure practices and their own plans for achieving net zero.

Jennifer Laidlaw: Okay. Great. Now you mentioned scenario analysis, and the NGFS has developed different scenario analysis. And I'm just wondering if you can maybe detail what they are and how they're helping inform climate stress tests for the banking sector.

Ravi Menon: So stress tests are a time-tested way in which financial institutions gain a better understanding of the risks that they are facing and how it's going to impact them. Forecasting is exceedingly difficult. So one has to think in terms of distinct scenarios and then ask oneself, if this scenario pans out, how is it going to -- what is the stress that it is going to create for my operations and my balance sheet and my asset book?

So that's something we do very often with respect to macroeconomic risks, financial stability risks, and we are now building scenarios for climate pathways. There are 2 broad categories of risks that need to be addressed. One is physical risk, which is a risk of climate change materializing in various forms and how that can affect our financial institutions assets.

Rising sea levels will have an implication for some assets, higher temperatures, heat waves that can affect some other activities and higher incidence of storms, typhoons, destruction or making some parts of the geography uninhabitable. I think these are the physical risks that the financial system needs to stress test against.

Then there are the transition risks, which really comprises the actions taken to mitigate climate change. Carbon prices is an example. If the effective carbon price either through a tax or some other means is going to be much higher in the future, how does that affect your assets? How does it affect your loan book, your investments? So again, these are questions that are built into these stress tests and scenarios.

Technological changes that might leave some assets stranded for instance, fossil fuels assets could get stranded if technological advancements lead to much lower prices for renewables or if there is government regulation that fosters the adoption of renewables or if there are changes in consumer patterns and demand patterns that pivot towards renewables.

So all these are possible pathways, which we need to address through scenarios. We have actually come up at the NGFS with 6 pathways, varying levels of these 2 types of risk: physical and transition risks. And they're broadly classified into 3 categories. One is orderly transition; two, disorderly; and three is what we call the hot house world.

So in an orderly transition, this is a good scenario. Climate change mitigation policies are introduced. They are early and then they gradually become more stringent. And so both physical and transition risks are relatively subdued.

The other scenario is a disorderly scenario, where action is delayed and then there is some degree of climate change and physical risk materializing, and then actions are accelerated in a hurry. And that would lead to higher transition risks because you will have to make this transition at a faster pace because you've not acted early enough. The world is probably on that trajectory currently.

Third is a really bad scenario, where really not much mitigating action is taken. There's a lot of talk but not much follow-through in which case climate change takes place. Maybe less transition risk, but a lot of physical risk. And some of these phenomena would be irreversible, and that would have a different set of implications.

Jennifer Laidlaw: Okay. Interesting, because it must be very challenging to see into the future to look at what carbon prices might be in a period of like 30, 40 years from now. What would you say are some of the main challenges facing banks when they're putting together their responses to these climate stress tests?

Ravi Menon: Yes. Huge challenges. It's not at all an easy area, as you said, given the considerable uncertainty about many of the variables and the assumptions. Two main sets of challenges, I would say. One is, of course, methodological, and two is data related.

So in terms of methodology, the typical models that banks and other financial institutions use for scenario analysis and stress testing are not quite able to assess the impact of climate-related shocks.

If you imagine, there is a serious recession in the European Union or China or anywhere else, the models that we have today can actually capture those effects and feed it through transmission mechanisms based on historical data. But acute physical risk events, rising temperatures, they're pretty hard because you don't have historical data. So methodology is tough. So we have to rely on climate-specific models.

And the other challenge is that many of these physical risks are geography specific. It's not as if we're going to have, I hope, floods not right across the world, but floods in many geographies. And in other parts of the world, it could be a different set of problems with temperature and not floods. So that kind of granularity is difficult at this stage of modeling technology to incorporate, but active work is taking place there, how to have more what I would call geographical resolution in the stress testing.

In data, that's the second big area, there are substantial data gaps. And we need to get better at having entity-level information, much of what I described affects entire regions or sectors. But when it comes down to the risks facing an individual bank, it needs to translate that into what are the implications or effects on those whom I have lent money to or those in whom I've made an investment in.

And that entity-level granularity is another area we need to address. And I think it's important to also incorporate actual developments so that this is not a purely theoretical exercise. And in a sense, the outbreak of war in Ukraine and the resultant spike in energy prices and the uncertainty over energy supplies, which is having implications across the world, in a sense, puts us in a disorderly transition scenario already, some would argue.

So if one had to cut dependence on Russian-supplied gas, then they would turn to, in the short term at least, to fossil fuels. But at the same time, they will probably speed up investments in renewable options over the medium term. So we have both effects taking place and then we need to discern what those implications are. In the short term, it will be not climate-friendly. In the medium term, it will be probably more climate-friendly than otherwise the case. And we're also noticing government's fiscal resources will be stretched.

So again, where those investments go to, especially in the context of macroeconomic stresses arising from the war, that's another consideration. So in the next round of scenarios work, the NGFS will focus on strengthening the modeling of the physical risks that I spoke about, both the acute risks, which are the episodic risks and then the chronic risks, which is sustained over a long period of time.

Jennifer Laidlaw: I was also really interested by the fact that you mentioned that there is generally a lack of data on climate-related issues. And in what ways are you working with banks and other central banks to overcome the data gap?

Ravi Menon: So one of the things that the NGFS has proposed is a global climate information architecture. So basically, we need to improve the quality of decision-making relating to climate by converging disclosure standards, harmonizing taxonomies and documenting the risk methodologies. So they all go together. You need to be able to procure good quality data. You need good definitions on what is -- how do you classify activities as to whether they are green or transition or brown, which means taxonomies basically, and then you need good disclosure templates.

So it's a whole value chain starting from this data to definitions and output through disclosure. And you need to take an integrated approach to this. Various bodies are working on these problems. International bodies have begun to step up their initiatives in this space.

The NGFS, on its part, has launched a data directory. This is basically to identify data gaps and needs. So it will map the climate-related use cases to the required measurement metrics and the raw data that is needed to construct the metrics. So people can refer to this.

This is like a public utility that central banks and other public agencies can go to, where they can then identify what is the data required to construct these risk metrics and measurement metrics that's needed for disclosure purposes. It doesn't store the data, but it tells you what kind of data you need and where you can find them and then you can go to those sources.

Jennifer Laidlaw: Okay. Interesting. Now we have some climate stress tests that have been carried out by central banks often using the NGFS scenarios. And what would you see as the lessons that have been learned from this experience about bank exposure to climate change? And what is there still to learn?

Ravi Menon: There's been a diversity of exploratory approaches. As you can appreciate, climate scenario analysis and stress testing is really in its infancy. Different central banks have taken different approaches because very often, there are jurisdiction-specific circumstances and objectives. So that shapes their design choices.

Some of the observations we've seen, we've found that it's useful for the climate scenarios to be augmented with macroeconomic and financial modeling work, the traditional type of modeling work that's tailored to each economy. So what we've seen is some central banks use their own proprietary, existing in-house macro surveillance, modeling techniques together with the NGFS scenarios. And I think when you do that together, you can generate more meaningful parameters.

You also need a lot of collaboration. You get good quality analysis when you bring supervisors and the financial industry together. Traditional approach is for the supervisors to set the parameters and let the financial institutions run the scenarios and that stress test. There's a bit of an arm's length dimension to this. I think here, we are all in a learning stage. It's not as if you're going to take supervisory actions after the stress test.

So I think there's a lot to be gained by collaboration actually, and that's something they're doing between the regulators and the financial institutions to do this work almost jointly. Of course, the financial institution has to adapt and apply the stress test to its own balance sheet.

But at this early stage of the game, I think there is merit in working together and also to include outside expertise. Much of the expertise lies in the climate science area, and we need to draw on some of these experts, third-party experts and the data providers. It's good that there is a growing industry now and industry players providing climate data. We need to incorporate them into these exercises.

So I think this is some of the early lessons. The estimates so far that we have seen from the climate-related stress tests, there is considerable uncertainty around them. The errors around these estimates are quite large. So we got to continue to enhance the models and address some of the estimation uncertainty.

We're also looking at going beyond static balance sheets to understand how to factor in mitigation strategies. So it's not as if maybe in the initial phase, not much action is taken, and then you have progressively worse climate outcomes. But then if there are mitigation strategies, then you can't be looking at a static balance sheet.

You've got to look at our dynamic balance sheet, which is financial institutions will also adjust their activities and balance sheets in response to some of this. So now that makes it even more complex, but that's going to be closer to what's going to happen in reality.

Jennifer Laidlaw: You mentioned these climate stress tests are not being conducted for supervisory reasons. In the future, what steps might regulators take to ensure financial institutions reduce their exposure to fossil fuels or other climate-related risks?

Ravi Menon: Yes. So that's an area that's being addressed by one of our work streams. At this point, the stress tests are still in their infancy. I think we are using them mostly for purposes of capability building, knowledge building and capability building. I think we'll reach a point not too far away when these stress tests become more actionable, then we can engage in more active discussions with the financial institutions as to how they should de-risk or gradually de-risk their portfolios.

But stress tests are not the only way to do this. As a large number of global financial institutions have signed up to net-zero commitments, we are encouraging more of them to also sign up to tangible decarbonization targets for 2030, because you can't leave this until 2050. You've got to start taking actions now.

And one of the issues we are addressing in the NGFS is how can supervisors be part of the conversation with financial institutions with respect to their transition pathways. Now some regulators, including the MAS, we are requiring financial institutions to report and disclose their climate-related financial risks. And this is going to become mandatory and has to be done in accordance with international standards so that there is comparability.

Now when they start doing that, then it becomes real because then market players are going to make their assessments as to how credible these transition plans are with respect to their -- what they have disclosed with respect to their risks. Are the transition plans on track to address the risks that are going to materialize over the next 3, 5 or 10 years?

And I think supervisors should be part of this dialogue. We need to figure out what is the best way in which we can add value and in motivating the financial institutions to actually, over time, put their portfolios on a pathway towards Paris-aligned net-zero outcome.

Jennifer Laidlaw: Okay. And you mentioned earlier some of the work that you were actually doing in Singapore on sustainability. What kind of role are you playing at the Monetary Authority of Singapore in testing Singapore's financial system for climate risks? And do you get a sense that the financial system in Singapore is actually addressing these risks as much as they need to?

Ravi Menon: Yes. So we're not very different from other leading regulators whom we work with very closely through the NGFS as well as other forums, basically to raise the level of understanding about environmental risks and climate risks. We go beyond climate to also address environmental risks. So we've issued a set of environmental risk management guidelines that covers areas like governance, risk mitigation and targets and metrics. How do you measure these risks? What are your targets? What are the metrics and so on?

So those guidelines are in place, and we've also conducted inspections to see how financial institutions, and this is not just banks but also insurance companies and asset managers, how they're applying the environmental risk management guidelines. And very recently, we published a set of information papers drawing on best practices in the application of these guidelines.

So one of the roles we play is facilitative information sharing, neutral arbiter of different methodologies and promoting best practices. We are finalizing our stress test for this year, an industry-wide stress test that will also apply to insurance companies and asset managers. And this stress test will also be used as a learning device as well as a device to prompt action on transition plans.

And that brings me to the third thing that we are going to do, which is to sit down with the financial institutions and discuss their transition plans. What are your targets for 2030? How do you intend to get there? How do you do this in a way that is least disruptive? And then what is the pathway towards net zero by 2050.

So I think you need a mixture, as in all supervision, a mixture of carrot and stick. Because it's early days, it's more carrot. Thankfully, the MAS also has a financial developmental role. So we're not just regulators. There is a lot we are doing to try to build up a vibrant green finance ecosystem. This includes things like providing grants to offset the costs of issuing green bonds, sustainability-linked bonds and so on.

We are actively involved in platforms, trying to build platforms for blended finance initiatives. We're also actively involved in the disclosure space. We just put out guidance on and requirements for ESG funds as to the kinds of disclosures they need to make. So you can't label yourself an ESG fund and make sales to retail investors unless you have a good disclosure to justify that label.

And we're also requiring them to have ongoing disclosures on how their funds are performing with respect to the initial strategies you have set out when you sold the fund to the investors. And we are also building up capabilities by encouraging centers of excellence to set up here. We've got about 2 or 3 of these now where they conduct research. They also conduct training.

I think the world is going to find a severe shortage of talent and expertise in these areas over the next 3 to 5 years. So we are putting together training programs, causes and so on and directing relevant parts of the financial sector workforce to pick up these skills. I think capability building across the industry is one of the key priorities for the MAS.

Esther Whieldon: Jen, I heard Ravi emphasizing that combating climate change is not something central banks are going to do alone, that it's very much a joint effort, be it with regulators, governments or financial institutions.

Jennifer Laidlaw: Yes, that definitely came through during our conversation. He said climate change is very much everyone's responsibility. He told me the financial system can be what he termed was a powerful enabler in greening the economy, but it can't do it alone.

Esther Whieldon: Well, do you keep us updated on any more developments from the NGFS going forward.

Jennifer Laidlaw: Yes, I certainly will.

Lindsey Hall: Thanks so much for listening to this episode of ESG Insider. And a special thanks to our producer, Kyle Cangialosi. 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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