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Central banks are finally taking action against climate change

The skyline with its banking district and the European Central Bank (ECB) is photographed in Frankfurt, Germany, August 13, 2019. REUTERS/Kai Pfaffenbach - RC1489AD06F0
Financial regulatory authorities are beginning to respond to the impact of climate change.
The impact of climate change on the stability of individual financial institutions and the financial system, in general, is growing. It influences the types of activities that financial institutions will fund and the cost of finance.

For example, the increased frequency and intensity of floods, storms, and droughts are complicating the insurance industry’s ability to assess insurable risks. It is also driving up insurance premiums.

It is affecting the ability of pension funds to plan their investment strategies. Banks are facing increased reputational and financial risks from financing activities that contribute to climate change. These activities include coal mining and cattle farming.

Globally, financial institutions and their clients are facing an increased risk of litigation for their failure to manage risks associated with climate change. For example, the Commonwealth Bank of Australia was sued for misleading investors by failing to disclose climate-related risks in its 2016 annual report.
Financial regulatory authorities are beginning to respond to these developments. The central bank of Brazil requires banks to explain how they treat environmental risks when determining their capital requirements. The central bank of China incorporates environmental factors into its monetary policy framework and financial stability assessments.
Image: ECB

New international standards encourage financial institutions to be more transparent about their exposure to climate-related risks.

It is against this backdrop that the recent decision by the South African Reserve Bank (SARB) to join the Network on Greening the Financial System must be viewed. The Network consists of 42 central banks and banking supervisory authorities, including central banks from China, England, France, Malaysia, Mexico, the Netherlands, and the European Central Bank.

The Network’s aim is to promote an effective environment and climate risk management in the financial sector. It also aims to mobilize mainstream finance to support the transition toward a sustainable economy. Its members recently warned that if banks don’t adjust to climate change “they will fail to exist”.

The creation of the Network is an implicit acknowledgment that central banks and other financial sector regulators have not always paid adequate attention to the environmental impacts of the financial sector. The Network’s existence is also an acknowledgment that the financial sector has a responsibility to become more environmentally responsible.

This is a challenge for central banks. Their independence requires them to act without fear or favor. But addressing climate change requires them to encourage financial institutions to favor certain types of activities over others. For example, the Lebanese central bank changes the number of reserves it requires banks to hold against their deposits according to how much they lend for renewable energy projects.

If central banks do not discriminate, financial institutions may continue financing activities that increase greenhouse gas emissions. This can raise the risk of droughts, floods, and more extreme temperature variability. This, in turn, can affect the quality and quantity of available land and water for producing food and constructing new housing, education, and health facilities. These factors can affect migration patterns, agricultural and other commodity prices. They can also affect aggregate demand, employment levels, public health and confidence in an economy. These are among the factors that often impact on financial stability and inflation.

Climate also poses a legal challenge
The South African Reserve Bank’s mandate is set out in the country’s Constitution. Article 224 states that the SARB must “protect the value of the currency in the interest of balanced and sustainable economic growth”. This is an unusual but not unprecedented mandate. Central banks with similar mandates include those of the Philippines, Russia, Malaysia, and Tanzania.
But what exactly does this mean? The term “balanced and sustainable growth” has no precise and universally accepted economic meaning. It is also not clear what the Constitution means when it says that the SARB’s mandate is to protect the value of the currency “in the interest” of “balanced and sustainable” growth.
As the SARB’s Governor recently noted, the Constitution “tells us what to do, but it is not explicit about how we do it”. This is true. The Constitution gives the SARB wide discretion in interpreting its mandate. The SARB currently interprets its mandate narrowly as requiring it to prioritize protecting the value of the currency. This certainly falls within the scope of its constitutional authority. However, it is not the only interpretation that would satisfy this requirement.


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