Abstract: In this paper, the author first analyzed the impact brought by the looming climate risk on the financial system from several perspectives and then reviewed the efforts of the global financial system to incorporate climate-related risk into finan-cial risk management frameworks. In the final part, he talked about how the financial system in China should improve capabilities of managing climate-related risks and how finance can contribute to the low-carbon transition of the economy and society.
“Achieving carbon emissions peak before 2030 and carbon neutrality by 2060” is a major decision made by the CPC Central Committee with President Xi Jinping at its core with careful consideration and argumentation. It is an important approach for China to deal with climate change and realize sustainable development of the Chi-nese nation, as well as an inherent requirement for implementing new development concepts and promoting high-quality economic development.
Hitting carbon peaking and carbon neutrality will inevitably bring about extensive and profound systemic reform of the economy and society, which will require the coordination and joint efforts of all departments, fields and industries to cope with. China’s financial system was among the first to conduct research on the development of green finance and has made great progress. In the next step, our work should focus on improving capabilities of managing climate-related risks, scientifically monitor and assess the impact of climate risks on the financial system, and support the green and low-carbon transition of the economy and society in an effective and orderly way.
I. RISKS AND CHALLENGES BROUGHT BY CLIMATE CHANGES ON FI-NANCIAL SYSTEM
Climate change will remain one of the greatest challenges facing humanity in the future, and its impact on the economy keeps growing.
According to the survey conducted by the Davos Forum for six consecutive years, two of the top ten risks with the highest probability of occurrence and the greatest impact in the future are related to climate change, namely extreme weather and fail-ure to mitigate or adapt to climate change.
Economic losses caused by climate change are becoming increasingly prominent. According to statistics, from 2000 to 2019, it has caused more than 7,300 natural dis-asters around the world, with economic losses of nearly 3 trillion US dollars, nearly double that of 1980-1999. If timely and effective measures are not taken to control global warming, natural disasters and extreme weather such as sea level rise, heat waves, heavy precipitation, droughts, tropical cyclones will become more frequent, and economic losses and the shock to asset values will continue to expand, exacer-bating "physical risks".
Transitioning to a green and low-carbon economy and society is the only way to deal with climate change. However, factors such as energy structure adjustment, techno-logical innovation, and changes in market preferences brought about by the transition will also affect traditional high-carbon industries, which may lead to rising costs of industries that heavily rely on traditional fossil energy. Some industries may even risk being replaced, leading to "stranded" assets and bringing about "transition risk".
The impact of climate risk on the real economy can be transmitted to the finan-cial system.
On the one hand, as the real economy is the foundation of financial development, the impact of climate risks on the former can be transmitted to the latter through various channels. Factors such as stranded assets and devaluation of collateral will affect the credit risk and market risk of the financial system, as well as the source of funds of financial institutions, exacerbating liquidity risks. At the same time, the business continuity and operational risks of financial institutions may be directly affected by climate risk such as extreme weather and natural disasters. Financial institutions also face reputational risks due to insufficient climate consideration in their investment and financing structures.
On the other hand, finance is the blood of the real economy, so financial risks will in turn damage the ability of the financial system to serve the real economy and affect economic development and transition.
Current risk management frameworks of financial institutions do not yet take climate into account.
Historically, financial risk management needs to dynamically respond to new prob-lems and challenges that emerge in reality. Taking bank risk management as an ex-ample, the Basel Committee on Banking Supervision (BCBS) issued Basel I in 1988, which required banks to measure credit risk and minimum capital adequacy ratio.
Later, in order to adapt to various financial innovations and the development of new risk management technologies, and to solve the problems exposed by the Asian fi-nancial crisis in 1997, the BCBS further improved the management requirements concerning market risks, operational risks and interest rate risks in Basel II. Mini-mum capital requirements, supervisory review process and market discipline were made the three pillars of the Basel regulatory framework.
After the outbreak of the global financial crisis, the BCBS adopted Basel III in 2010, and drew lessons from the crisis. While raising capital requirements and introducing counter-cyclical capital buffers, the BCBS also established regulatory indicators for leverage and liquidity. In the context of the increasingly prominent impact of climate risks, incorporating climate factors into risk management frameworks will become a trend in the future.
II. THE INTERNATIONAL COMMUNITY HAS EMBARKED ON A STUDY OF INTEGRATING CLIMATE-RELATED RISK INTO FINANCIAL RISK MANAGEMENT FRAMEWORKS
The international community has done a lot of work on the management of climate-related risks. The Financial Stability Board (FSB) released the FSB Roadmap for Ad-dressing Climate-Related Financial Risks in 2021, proposing that climate-related risks should be incorporated into the overall framework of financial risk management to improve the resilience of the financial system to climate risks. Other international organizations are also actively carrying out work related to managing climate-related risks.
In terms of information disclosure, the Task Force on Climate-Related Financial Disclosures (TCFD) established by the FSB put forward a set of clear recommenda-tions for climate information disclosure, which has received support from more than 2,600 institutions and organizations. The International Financial Reporting Standards Foundation (IFRS) established the International Sustainability Standards Board (ISSB) in 2021, and planned to launch an internationally accepted climate-related regulatory reporting standard. By then, the International Organization of Securities Commissions (IOSCO), various international financial organizations and industry standard formulating agencies are likely to adopt this standard. In China, the People's Bank of China (PBC) issued the Guidelines for Financial Institutions Environmental Information Disclosure to encourage financial institutions to strengthen risk man-agement from the aspects of identification, assessment, management, and control procedures of environmental risks.
In terms of data on climate-related risks, central banks and the Network for Green-ing the Financial System (NGFS), the International Monetary Fund (IMF), and the FSB have started to build a forward-looking indicator that reflects the impact of cli-mate change and green and low-carbon transition on the financial system. The NGFS working group on bridging the data gap under the NGFS has comprehensively sorted out the needs, types and application scenarios of climate-related data. In addition, the NGFS proposes three foundations for addressing data issues, namely globally con-sistent information disclosure standards, globally accepted taxonomy for sustainable finance, and sound measuring standards and methods for climate-related risk.
In China, the PBC supports qualified regions to establish carbon accounts, laying a data foundation for financial institutions to carry out carbon accounting and better support green and low-carbon development. For example, Quzhou City in Zhejiang Province collects real-time emission-related data from enterprises through the instal-lation of collection terminals, and builds carbon accounts for industry, agriculture and individuals. Guangzhou City, Chongqing City, Changji Prefecture and Karamay City in Xinjiang Uygur Autonomous Region, and Qiqihar City in Heilongjiang Prov-ince have also created their unique carbon accounts.
In terms of vulnerability analysis, the BCBS delves into the drivers of climate risk and the channels through which it is transmitted to the financial system, and summa-rizes the methods for measuring climate-related financial risks. Based on factors such as climate warming goals and policy transformation efforts, the NGFS com-bines climate models with macroeconomic models to develop a relatively complete set of climate scenarios, which provides an important basis for countries to conduct climate scenario analysis and stress test. The central banks of major economies such as the European Union, Japan, and the United Kingdom are exploring how to carry out stress test on climate-related risks, and many large international banks have also conducted tests on their own or under the organization of regulators.
In terms of regulatory practice, the BCBS has specially established a high-level working group on climate risks to study the feasibility and ways of incorporating climate-related risks into the Basel regulatory framework. It also formulated the Guiding Principles for Effective Management and Supervision of Climate-Related Risks, after soliciting public opinion. The International Association of Insurance Su-pervisors (IAIS) released the Application Paper on Climate-Related Risk Regulation in the Insurance Sector, which provides regulatory advice on corporate governance, internal control, solvency risk management, investment, and information disclosure. The European Central Bank published the Guide on Climate-related and Environ-mental Risks, which explains how the ECB expects banks to prudently manage and transparently disclose such risks relating to business models and strategies, corporate governance and risk appetite, risk management, and information disclosure. This will apply to those important financial institutions under its direct supervision.
III. IT IS SUGGESTED THE FINANCIAL SYSTEM TAKES CLIMATE-RELATED RISK STRESS TEST AS A STARTING POINT, AND STRIVES TO IMPROVE CLIMATE-RELATED RISK MANAGEMENT CAPABILITIES
Stress test is an important tool for managing climate-related risks.
Climate risks can be enduring, global, and structural, making traditional risk moni-toring and analysis methods difficult to apply. Therefore, forward-looking stress test is particularly important in managing climate-related risks. At present, financial management departments of major international economies generally conduct quan-titative assessments of climate-related financial risks by carrying out stress tests.
In terms of participants, among financial institutions, participating in the tests are mainly banks, and in some economies there are also insurance institutions and pen-sion funds. Tests mainly target at high-carbon industries or all industries.
In terms of types of risks, most economies focus on analyzing the translation of transition risks into the credit risk of financial institutions, and some economies also analyze the translation of transition risks into market risks, or the translation of phys-ical risks into underwriting risks.
In terms of the time period of stress tests, most economies take 30 years for as-sessment to reflect the long-term nature of climate risk. Some economies choose a shorter time period to ensure the reliability of forecasting.
From the perspective of balance sheet assumptions, most countries adopt static balance sheet assumptions due to the consistency and reliability of data.
In terms of testing methods, most economies adopt the method of macro-scenario analysis, and some economies use sensitivity analysis. The former analyzes the pos-sible losses of the financial system by assuming policies to deal with climate change and the corresponding climate change path. The latter studies the direct impact of changes in individual drivers for transition risk such as carbon prices and carbon bor-der adjustment taxes on the financial system or a financial industry or institution.
The PBC has completed the first phase of climate-related risk stress test.
In 2021, the PBC organized 23 big banks across the country to carry out the first phase of stress testing on climate-related risks, targeting at the three high-carbon in-dustries of thermal power, steel, and cement, for the purpose of analyzing the in-creasing rate of loan defaults due to rising costs from that time to 2030, under the circumstance of introducing a payment mechanism for carbon emission, and the im-pact on the bank's capital adequacy level.
In order to ensure prudence, the test assumed that no technological progress took place in the industry, that an individual enterprise had no bargaining power with both upstream and downstream industries, and that an insolvent enterprise was unable to make repayment. In terms of the specific path of risk transmission, the PBC estab-lished a basic model for measuring default probability of non-financial enterprises for the first time using "one set of machine learning algorithm and 21 industry mod-els". Participating banks adopted internal rating model to measure corporate default changes on a firm-by-firm and year-by-year basis.
Test result shows that if enterprises in the thermal power, steel and cement industries do not embark on the low-carbon transition, their repayment ability will decline to varying degrees under stress scenarios. The 23 national banks participating in the test have a low proportion of loans in the three industries, so their overall capital adequa-cy ratios can meet regulatory requirements under the three stress scenarios.
In the next stage, the PBC will continue to improve the stress testing method on climate-related risks. The first is to improve the stress scenarios and transmission path in a way that is more in line with China’s actual situation, so as to increase the application value and guiding significance of the test results. The second is to further expand the scope of industries covered by the test to cover more high-carbon indus-tries, and to analyze the climate risk exposure of the country’s financial system more comprehensively. The third is to explore and carry out stress tests based on macro-scenarios on climate risks to more systematically assess the structural and cross-cutting impacts brought about by the green and low-carbon transition of the economy and society.
IV. THE FINANCIAL SYSTEM NEEDS TO EFFECTIVELY AND ORDERLY SUPPORT THE GREEN AND LOW-CARBON TRANSITION OF THE ECONOMY AND SOCIETY ON THE BASIS OF SOUND MANAGEMENT OF CLIMATE-RELATED RISKS
It was pointed out at the meeting of the Political Bureau of the CPC Central Commit-tee on July 30, 2021 that in order to achieve carbon neutralization in a coordinated and orderly manner, we must take a holistic approach from a state perspective and avoid campaign-style carbon reduction. The financial system must do a good job in managing climate-related risks. It has to make good use of stress tests, the “monitor” and “dashboard” of climate-related risks, balance the relationship between economic development and emission reduction, and take into consideration of both overall and local, short-term and medium-to-long-term needs. In this way, the financial system can better support the steady and orderly transition of the real economy, and help achieve the goal of carbon neutrality.
Financial institutions should gradually establish a climate-related risk manage-ment framework and incorporate climate risk into corporate strategy and pref-erence management. First, they need to incorporate climate-related risk manage-ment into medium- and long-term development plans, and assess the medium- and long-term impacts of climate risks on the business of financial institutions. The sec-ond is to include climate-related risks in the comprehensive risk management sys-tem, clarify the responsibilities for the "three lines of defense", and integrate climate risk factors into the entire process of risk management. The third is to consider cli-mate risk during the whole process of investment and financing business, and strengthen classified management of the aforementioned business. The fourth is to promote the practice of climate stress testing, and provide forward-looking guidance on the adjustment of investment and financing structure and risk prevention and con-trol.
Strengthen the collection of climate risk data and consolidate the basis for cli-mate-related risk analysis. The measurement and estimation of climate risk data is highly specialized, and requires joint efforts of relevant government departments, financial institutions, and enterprises to continuously improve data reliability and availability, as well as the consistency of accounting methods. The PBC has been developing accounting methods for carbon emission and emission reduction for fi-nancial institutions. The latter should also improve their awareness and ability to manage climate risk data, and do a good job in the collection and integration of cli-mate risk information, such as macro climate and policy data, micro carbon account-ing and financial data, and ESG data. They are also suggested to develop big data about climate risk and continuously improve the pertinence and effectiveness of climate-related risk management.
Further promote the development of green finance and be a "booster" for the development of green industries. The first is to complete the standard system for green finance to align domestic standards with international ones. The second is to expand green financial products and services, and establish a professional and com-prehensive system that covers green credit, green bond, green insurance, green industry fund, green trust, green leasing, green asset securitization, so as to meet the diversified financing needs of businesses. The third is to make full use of support tools for carbon emission reduction, and increase support for key areas such as clean energy, energy conservation and environmental protection, and emission reduction technologies.
Increase the empowerment through science and technology, promote the inte-grated development of green finance and inclusive finance, and be an "amplifi-er" for the green and low-carbon transition of small and micro enterprises and agriculture, rural areas and farmers. The financial system should carefully exam-ine the internal connection between green finance and inclusive finance, and make coordinated planning and promote the two as a whole. It is essential to identify the place where the standards and rules for green finance and inclusive finance converge, and promote the practice of integrated development of the two. At the same time, it is necessary to speed up the development and application of financial technology so as to solve the problem of information asymmetry, revitalize green assets, promote environmental information disclosure, and reduce the cost of inclusive finance.
Strengthen the research and practice of transition finance, and be a "stabilizer" for the transition and upgrading of high-carbon industries. While managing cli-mate-related risks and developing green finance, the financial system must consider China’s resource endowment of “rich in coal resources and poor in oil and gas” and the status quo that traditional high-carbon industries still occupy an important posi-tion in the national economy. It must recognize the financing needs for green and low-carbon transition of those emissions-intensive market entities, economic activi-ties and asset projects. On the basis of making good use of the special re-lending funds that was launched to support the clean and efficient utilization of coal, efforts are needed to accelerate the establishment of standards for transition finance, sort activities that meet the features of transition and clarify technical indica-tors, and encourage financial institutions to devise and launch more abundant financial tools for transition. These efforts can better support the green transition of traditional high-carbon industries and have transition finance and green finance complement each other.
Carbon neutrality brings not only new constraints, but also driving forces and oppor-tunities for high-quality development of the Chinese economy and finance. The fi-nancial system must accurately and comprehensively implement new development concepts and build a new development pattern. On the basis of continuously improv-ing climate-related risk management capabilities, the financial system should adopt systematic thinking to support the green and low-carbon transition of the economy and society, and contribute to the country’s high-quality development.
This article will be published on China Finance, Vol. 05, 2022. It is translated by CF40 and has not been reviewed by the author himself. The viewpoints herein are the author’s own and do not represent those of CF40 or other organizations.
