The importance of being forward-looking: managing financial stability in the face of climate risk

The relation between climate change and financial risk has gained unprecedented attention and there is now growing consensus on the fact that climate risk is material. Yet, the vast majority of private and public financial capital is not aligned with the climate targets of the 2015 Paris Agreement. This misalignment can be a source of risk for financial institutions. A fundamental difficulty with assessing and managing climate-related financial risk comes from the fact that it is largely endogenous and involves multiple scenarios. The author discusses the benefits of a framework of climate-related financial risk management under uncertainty that combines the climate stress test approach with decision theory under uncertainty. This approach makes it possible to reconcile financial stability objectives with the multiplicity of future climate policy scenarios. In debates about financial stability in the face of climate risk, central banks have an important role to play in terms of leadership by example. However, the data necessary to manage climate financial risk are complex and currently fragmented. Since these data are critical for markets to factor climate-related information into prices, regulators could support the case for a public entity with the mandate to collect, validate and make available climate-relevant data at the European Union level.