China will aim to hit peak emissions before 2030 and for carbon neutrality by 2060, President Xi Jinping has announced. The “Dual Carbon” pledge will bring systematic changes to economy and society, and requires coordinated efforts of all relevant parties. Next steps for China’s financial system are to improve its climate risk management capacity, evaluate impacts incurred from climate risk, and support an orderly green transition.
Looming challenges and risk of climate change for financial system
Climate change, one of the gravest challenges facing the humanity, is exerting a growing economic impact. Extreme weather and climate action failure, both related to climate change, are among top 10 risks with potentially the most severe impact over the next decade identified by World Economic Forum Global Risks Reception Survey for six consecutive years. The economic losses caused by climate change are manifesting. Statistics show that climate change has caused over 7300 natural disasters worldwide from 2000 to 2019, with economic losses of nearly $3 trillion, almost doubling the 1980-1999 figure. If global warming fails to be contained in time, there will be more frequent natural disasters and extreme weather such as sea level rise, heat waves, heavy rain, droughts and tropical cyclones, incurring more economic losses and greater impacts on asset value and heightening the "physical risks". Green transition is the inevitable path to address climate change, but it will impact high-carbon industries with changes in the energy mix, technological innovation and market preferences. This leads to increased carbon emission costs or industrial substitution shocks for industries highly reliant on traditional fossil fuels, resulting in stranded assets and posing "transition risks."
The impact of climate risks on the real economy can be transmitted to the financial system. On one hand, the real economy is the foundation of finance. Therefore, factors such as stranded assets and collateral depreciation will affect credit risk and market risk of the financial system, as well as the funding sources of financial institutions, exacerbating liquidity risks. In addition, the business continuity and operations of financial institutions may be directly affected by climate risks such as extreme weather and natural disasters. Financial institutions may also face reputational risks due to insufficient climate consideration in their investment and financing structures. On the other hand, finance is the lifeblood of the real economy, and financial risks will in turn undermine the financial system's ability to serve the real economy, affecting economic development and transformation.
The current risk management frameworks of financial institutions have yet to fully incorporate climate factors. Throughout history, the rules of financial risk management have evolved in response to new issues and challenges in the real world. Taking bank risk management as an example. In 1988, the Basel Committee on Banking Supervision (BCBS) established Basel I, prescribing requirements for bank credit risk calculation and minimum capital adequacy. Later, to adapt to financial innovations and emerging risk management technologies and fix the problems exposed by the Asian financial crisis in 1997, BCBS tightened requirements for managing market risks, operational risks and interest rate risks in Basel II, and made minimum capital requirements, supervisory review process and market discipline as the three pillars of the Basel regulatory framework. Drawing lessons from the 2008 global financial crisis, BCBS introduced Basel III in 2010. Basel III not only raised capital requirements and introduced countercyclical capital buffers, but also established leverage and liquidity ratio requirements. Against the backdrop of the growing prominence of climate risks, incorporating climate factors into risk management frameworks is expected to become a future trend.
The international community has initiated research on integrating climate risks into the financial risk management frameworks
The Financial Stability Board (FSB) released the FSB Roadmap for Addressing Climate-related Financial Risks in 2021, proposing to incorporate climate risks into the overall framework of financial risk management and enhance the climate resilience of the financial system. Other international organizations in the financial sector are also actively advancing the work on climate risk management.
On information disclosure, the Task Force on Climate-related Financial Disclosures (TCFD) established by the FSB has proposed a clear set of climate information disclosure recommendations that have received support from over 2600 institutions and organizations. The International Financial Reporting Standards Foundation (IFRS) established the International Sustainable Standards Board (ISSB) in 2021, planning to introduce internationally recognized climate-related regulatory reporting standards that might be adopted by the International Organization of Securities Commissions (IOSCO), international financial organizations and industry standard-setting agencies. PBC has released the Guidelines on Environmental Information Disclosure for Financial Institutions, asking financial institutions to strengthen risk management through environmental risk identification, assessment, management and process control.
On climate risk data, the Central Banks and Supervisors Network for Greening the Financial System (NGFS), the International Monetary Fund (IMF) and the FSB are working to build forward-looking indicator systems that reflect the impact of climate change and the green low-carbon transition on the financial system. NGFS’s Workstream on Bridging Data Gaps has reviewed the needs, types, and application scenarios of climate related data. In addition, NGFS also proposes three building blocks for addressing data-related problems, namely: (i) a rapid convergence towards a common and consistent set of global disclosure standards; (ii) efforts towards a minimally accepted global taxonomy/share principles for sustainable finance classifications; and (iii) the development and transparent use of well-defined and decision-useful metrics, certification labels and methodological standards. In China, the PBC supports qualified regions to establish carbon accounts, preparing a data foundation for financial institutions’ carbon accounting and support for green and low-carbon development. For example, Quzhou City in Zhejiang Province has installed data collectors to gather real-time data on corporate carbon emissions, building carbon accounts for industry, agriculture, and individuals; Guangzhou, Chongqing, Changji Prefecture and Karamay City of Xinjiang Uygur Autonomous Region, and Qiqihar City of Heilongjiang Province have also created their own carbon accounts.
On vulnerability analysis, BCBS has conducted in-depth research on the drivers of climate risks and the channels of their transmission to the financial system, and summarized the measurement methodologies of climate-related financial risks. Combining climate models with macroeconomic models, NGFS has developed a comprehensive set of climate scenarios based on global warming goals, policy transformation intensity and other factors, providing an important foundation for countries to conduct climate scenario analysis and stress testing. Central banks of major economies such as the European Union, Japan, and the United Kingdom are all exploring climate risk stress tests, and many large international banks have conducted such tests either voluntarily or under the regulators’ supervision.
On regulatory practices, BCBS has established a high-level working group on climate risks to study the feasibility and ways of incorporating these risks into the Basel regulatory framework. It has finalized the Principles for Effective Management and Supervision of Climate-related Financial Risks, which are currently open for public opinions. The International Association of Insurance Supervisors (IAIS) has issued the Application Paper on the Supervision of Climate-related Risks in the Insurance Sector, putting forward regulatory recommendations on corporate governance, internal control, solvency risk management, investment, information disclosure, etc. The European Central Bank (ECB) has released the Guide on Climate-related and Environmental Risks, setting regulatory expectations for financial institutions' business models and strategies, corporate governance and risk appetite, risk management, and information disclosure. The Guide will apply to those important financial institutions directly under ECB’s supervision.
Climate Stress Test: Financial System’s lever to enhance climate risk management capacities
Climate risks are characterized by their long-term, global, and structural nature, making it challenging to apply traditional risk monitoring and analysis methods. Therefore, forward-looking stress test plays a crucial role in climate risk management, and is widely employed by financial authorities of world’s major economies for quantitative assessments of climate-related financial risks. Main characteristics of climate stress test are as follows:
1. Participants: mainly banks, with insurance institutions and pension funds in some economies;
2. Target industries: high-carbon industries or all industries;
3. Types of risk: transition risks on credit risk of financial institutions in most economies, with additional analyses on transition risks on market risk or physical risks on underwriting risk in some economies;
4. Time horizon: mostly 30 years, shorter in some economies to ensure reliability of prediction;
5. Balance sheet assumptions: static assumptions in most countries to guarantee data reliability and consistency
6. Methodology: macro-scenario analysis in most economies, with sensitivity analysis in some.
PBC has completed the first phase of climate risk stress test. In 2021, PBC organized 23 major banks nationwide to conduct phase I. The test focused on three high-carbon industries: thermal power, steel, and cement. It analyzed the impact on loan default probabilities and subsequent effects on bank capital adequacy levels due to cost increases resulting from the introduction of carbon pricing mechanisms from the present to 2030. To ensure prudence, the testing assumed no technological progress in the industries, no bargaining power for individual enterprises in the upstream or downstream sectors, and no repayment capacity for heavily indebted companies. Regarding the specific transmission pathways of risks, PBC established a basic model for non-financial corporate default probabilities based on "one set of machine learning algorithms and 21 industry models." Participating banks used internal rating models to calculate default changes on an individual basis and year by year basis. The test results indicated that if companies in the thermal power, steel, and cement industries do not undergo low-carbon transition, their repayment capacity would decrease under stress scenarios. However, since the loans to these industries account for a small proportion of total loans for the 23 participating banks, their overall capital adequacy ratios would meet regulatory requirements under the three stress scenarios.
Next, PBC will further improve its climate risk stress test methodology, aiming to make it more aligned with China’s reality, cover more industries, and explore feasibility of macro-scenario climate stress testing.
Financial System: Supporting an orderly green transition while managing climate risk
On July 30, 2021, the meeting of the Political Bureau of the Central Committee pointed out that, China should achieve its dual carbon targets orderly. It called for corrections to be made to “decarbonization frenzy”, a halt to the dismantling of existing energy infrastructure before new options are available. Financial system should leverage the stress test to improve its climate risk management capacities, and balance the transition of real economy and realization of “Dual Carbon” targets.
Financial institutions should gradually establish a climate risk management framework and take climate risks into consideration as part of their business and risk management strategies. In addition, climate risks should be visited throughout business process, and climate risk stress test should be improved.
Strengthen climate risk data collection abilities and consolidate foundations for climate risk analysis. PBC is exploring the development of carbon emissions and carbon reduction accounting methods for financial institutions. In the meantime, financial institutions should also enhance their awareness and ability in managing climate risk data, collect and integrate climate risk information such as macro climate and policy data, micro carbon accounting and financial data, ESG data, etc. The goal is to establish climate risk big data, and continuously improve the relevance and effectiveness of climate risk management.
Financial system should reposition itself as“Booster” for the development of green finance and green industries. First, the green finance standards system should be improved to achieve domestic consistency and international alignment in areas such as green finance and green industries. Second, a comprehensive range of specialized green financial products and services should be developed to meet the diverse financing needs of enterprises. Third, carbon reduction support tools should be utilized to intensify support for key areas such as clean energy, energy conservation and environmental protection, and carbon reduction technologies.
"Amplifier" for green transition of small and micro businesses and entities related to agriculture, rural areas and farmers. The financial system should analyze the correlation between green finance and inclusive finance, and deepen the integration of the two. In addition, fin-tech should be accelerated to remove information asymmetry between green finance and inclusive finance, activate green assets, promote environmental information disclosure, and reduce the cost of inclusive finance.
"Stabilizer" for the transition and upgrading of high-carbon industries. When managing climate risks and developing green finance, the financial system should build on China’s reality and properly handle the financing needs of carbon-intensive market players, economic activities and green low-carbon transition of asset projects. Besides the special refinancing to support the clean and efficient use of coal, financial institutions are encouraged to design and launch more transition financial instruments, providing support for green transition of traditional high-carbon industries and achieving positive interaction between transition finance and green finance.
For China's economic and financial sectors, carbon peaking and carbon neutrality are not only new constraints, but also drivers and opportunities to achieve high-quality development. The financial system should fully, accurately, and comprehensively implement the new development concepts and shape a new development pattern. With the continuous improvement of climate risk management capabilities, it should support the systematic, orderly, and effective green and low-carbon transformation of the economy and society, contributing more financial wisdom and strength to achieve high-quality development.
By Liu Guiping, deputy governor of PBC
This article was published in China Finance, 2022, Issue 5