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Central banks' key policy goals are under threat from climate change, warns UBS

Key Points
  • Although the study revealed that central banks are "conscious of their fiduciary duty" to the public, just 9% have taken specific measures related to climate risk which go beyond basic requirements within broader environmental, social and governance (ESG) frameworks required by most public institutions.
  • A detailed report from UBS global sovereign market strategists Massimiliano Castelli and Philipp Salman suggested "there is growing empirical evidence that climate risk affects the two policy goals pursued by the central banks."

Central banks around the world must proactively fight climate change in their own investment portfolios in order to safeguard their key priorities, according to research.

A survey of central banks, carried out by UBS Asset Management, revealed that 62% believed a fiduciary duty to the general public was a key motivation for working climate risk into the management of their own assets.

However, while 56% said they had noticed increased interest from peers in environmental issues, only 6% indicated that they had experienced increased scrutiny from politicians or supervisory bodies regarding the inclusion of climate risk criteria in their own investment processes.

Although the study revealed that central banks are "conscious of their fiduciary duty" to the public, just 9% have taken specific measures related to climate risk which go beyond basic requirements within broader environmental, social and governance (ESG) frameworks required by most public institutions.

Such frameworks require institutions and companies to document the broader impact of their operations on each of these three criteria, and serve as an indicator of future financial performance in terms of risk and reward.

Two-thirds of central banks indicated that technical difficulties due to a lack of available benchmarks to represent ESG impact were the key obstacles to including climate considerations in their portfolios.

Just over half suggested they would only accept lower returns if the respective benchmark was changed, while 72% indicated they would not be willing to take a more active ownership approach that required greater engagement with companies.

Physical and transition risk

Despite the apparent lack of engagement thus far, a detailed report from UBS global sovereign market strategists Massimiliano Castelli and Philipp Salman suggested "there is growing empirical evidence that climate risk affects the two policy goals pursued by the central banks."

This first of these is physical risk. Extreme weather events and climate pattern disruptions impact financial stability via negative impacts on the banking and insurance sectors, the report suggested.

However, such events can also impact the monetary stability goal, as "they have the potential to increase uncertainty with regards to inflation and growth forecasts which are the basis for the setting of interest rates," it added.

The second, transition risk, refers to policy evolution through time and across governments on climate risk, which also affects central banks.

"The corporate and financial sectors will have to adapt to the evolving policy and regulatory framework surrounding climate risk - i.e. reduction of CO2 emissions and carbon pricing - but significant uncertainty exists about the forms and the timing of these changes," the UBS report stated.

"What is certain is that these policies will create disruption as institutions adapt, potentially impacting both the financial stability and monetary policy goals of central banks."

Climate risk also affects the asset management operations of central banks, as with any other institutional investor's portfolio. States and sectors adjusting to new climate change realities could mean central banks face losses on asset holdings exposed to climate risk, the economists highlighted. Risk mitigation operations, such as re-allocating assets to holdings with less exposure to climate risk or stronger ESG focus, will therefore be necessary.

Castelli and Salman highlighted the Dutch Central Bank (DNB), the Bank of England and the People's Bank of China as being at the vanguard of driving green finance measures.

Looking ahead

Almost half (45%) of respondents to the UBS Annual Reserve Manager Survey 2019 suggested that the inclusion of climate risk criteria in asset management activities would be achieved through an exclusion list.

The asset classes where central banks see greater scope for climate risk inclusion are corporate and government bonds.

"The results of our RMS survey hint that most prefer to implement — or, in many cases, have already implemented — a comprehensive ESG framework with the help of established data providers," Castelli and Salman wrote.

"A major contribution central banks can provide in the greening of the financial system is to create standards and an international level playing field."