Chief Economist’s Corner: Climate change is one of the greatest threats to financial stability

Central bankers, economists and academics increasingly agree that rising temperatures are one of the major issues challenging financial stability. This might impact monetary policy in the future, explains Nordea Chief Economist Helge J. Pedersen.

Everybody talks about the weather, but nobody does anything about it. The old quote by Charles Dudley Warner has probably been true for thousands of years, but now something seems to be changing. We have really entered the climate era. In Denmark, the new government has already announced a very ambitious target of reducing CO2 emissions by 70% by 2030. With its declaration of a climate emergency in Europe and globally last week, the European Parliament is now following suit. The ambition is that the EU reduces greenhouse gas emissions by 55% by 2030 and achieves net-zero emissions by 2050.

This happened ahead of the UN COP 25 climate conference currently taking place in Madrid. It will now be up to the new president of the European Commission, Ursula von der Leyen, and her commissioners to ensure that the EU’s budget policy is designed to meet these requirements. As one of its wishes, the European Parliament wants the European Commission to ensure that all budget and legislative proposals are fully compatible with the target of keeping global warming below 1.5 degrees Celsius. And it’s clear that Europe needs action.

Helge J. Pedersen, Nordea Chief Economist

Helge J. Pedersen, Nordea Chief Economist

In a recent report, the European Investment Bank (EIB) concluded that Europe (perhaps in contrast to received wisdom) is lagging both the US and China when it comes to climate investment. While the EU invested around 1.2% of GDP in measures to combat climate change last year, the US invested 1.3% and China a hefty 3.3%.

It’s obviously important to have a well-thought-out strategy for the green transition to be successful. But it’s just as important to secure the necessary funding. Estimates suggest that the EU countries need to invest between EUR 180bn and EUR 290bn annually in the green transition to live up to the target.

That’s a lot of money, but the stage has been set. In political circles across Europe, there are signs that the low interest rate environment could lead to a more expansionary fiscal policy. And that this policy should to a large extent be targeted towards investment that lifts long-term growth rates and helps to solve the climate problems.

The market for green bonds, launched more than a decade ago by the World Bank and the EIB, has moreover seen tremendous growth. Since 2008 governments and institutions globally have issued green bonds worth nearly EUR 700bn – an amount which has grown almost exponentially in recent years. Considering the climate hype, this is clearly just the tip of the iceberg. In Denmark, the debate over green government bonds has also flared up. The central bank and the finance ministry are exploring options for adding a green element to government bond issuance which continues to support a liquid and well-functioning Danish government bond market. This project has even been included in the government budget.

But fiscal policy is not the only policy area coming into play in today’s climate battle. Christine Lagarde, the new president of the ECB, has proposed that Euro-area monetary policy should be subject to a strategic review. This includes the possibility that the ECB may buy green bonds as part of its purchase programme. And considering that in addition to its monetary policy mandate, the bank is also ultimately responsible for financial stability in the Euro area, perhaps it makes a lot of sense.

Central bank heads, economists and academics increasingly agree that rising temperatures are one of the major issues challenging financial stability. The increasingly frequent climate disasters with flooding, droughts, hurricanes and forest fires lead to the severe destruction of farm land, crops, property and capital assets as well as the disruption of corporate value chains. This leads to serious losses in the financial sector – for banks, pension funds and insurance companies – when the damage is assessed.

But climate change also triggers more indirect erosion of economic value. Land and property prices will drop markedly in the affected areas. And the green transition entails high costs for the CO2-intensive business sectors, which may even be outmatched unless they climate-proof their production in time.

So we might as well start memorising the UN’s 17 sustainable development goals. Because they form the basis for the ESG criteria which all businesses today must comply with if they are to have any chance of success in the 2020s. So there is no doubt about it. Now something must be done about the weather. What would Warner have said if he were alive today?

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