Good afternoon to you all.

It is a great pleasure to be here to address the participants in yet another edition – the 4th edition - of ISEG’s Sustainable Finance Course. Thank you Clara and Sofia for having me.

Let me start by quoting Mark Carney, former Governor of the Bank of England, who for many years has been a consistent and committed promoter of a greener financial system. In a speech in 2019, Mr Carney said:

“Like virtually everything else in the response to climate change, the development of a more sustainable financial system is not moving fast enough for the world to reach net zero.”

In the past three years - in spite of major “distractions”, such as the pandemic and the Russian invasion of Ukraine and ensuing energy crisis - important steps have been taken to build a more sustainable financial system.

Nonetheless, we are not close to moving fast enough, nor going far enough, and Mark Carney’s quote remains as valid today as it was three years ago.

Nobody can shy away from getting involved and contributing to the transition to a more sustainable way of living.

This is why training programmes such as this Sustainable Finance Course are so necessary and so important. They widen the number of people with an understanding of the sustainability challenges we face, providing them with the analytical tools to evaluate related risks and opportunities. By investing time on this course and by bringing this new knowledge to your daily lives in companies, financial institutions or public undertakings, you are contributing to informed, fact-based decisions that translate into better public policies and a better use of resources.

Given the nature of this talk and the limited time available, I shall privilege breadth, leaving deeper analyses of issues that are more specific to the Q&A part, and to the classes you will be attending in this course.

I have structured the talk around three broad topics:

• The climate challenge in a nutshell;
• Scaling up green finance – what is missing? 
• How can central banks and financial supervisors help?

For ease of presentation, I will essentially be talking about climate change – which has been the main focus of attention; however, it is clear that the environmental challenge is much broader, and encompasses other important topics such as biodiversity loss. Likewise, the social and governance dimensions of sustainability bring to the fore additional issues that must not be neglected.

 

1. The climate challenge in a nutshell

When dealing with a complex problem, it is useful to pause frequently and recall what is at stake in the simplest possible manner – or as some in project management say, it is useful to “slice the elephant”.

Asking basic questions and answering them in simple terms, helps us stay focused on what really matters. 

So, running the risk of sounding repetitive and simplistic, let me try to do exactly this.

The first obvious question is of course: What is the problem? 

The problem is – as we all know - global warming.

The average global temperature is currently 1.1oC higher than its pre-industrial level. If no action is taken, the temperature will continue to rise, probably at a faster pace, and the so-called “tipping points” - abrupt and irreversible changes in the earth’s climate system causing severe long term damage - are likely to occur.

Having identified the problem, the next logical step is understanding why the problem emerged in the first place.

The next question is therefore: What is the root of the problem? 

Here too evidence is overwhelming, and the scientific consensus is unusually large: current global warming is the result of human activity.

A significant part of the energy we use today still comes from fossil fuels like oil, coal or natural gas, which release greenhouse gases (GHG), mostly CO2, when burnt. These gases accumulate in the atmosphere, affecting temperature, rain patterns, sea levels and the frequency and severity of natural disasters. The heatwaves, wildfires and severe droughts we are experiencing across the globe are only the latest and closest reminder of where we are heading. 

This massive social cost is not taken into account in the decisions of producers, consumers or investors because it is not reflected in the prices of goods and services, nor in the cost of capital. As economists like to put it, we are in the presence of an externality – indeed, in the words of Professor Nicholas Stern, the “greatest market failure the world has seen”..

Therefore, we have a pretty consensual diagnosis: a serious global warming problem caused by human activity that we need to address forcefully and urgently.

The next – and arguably more difficult - step is to define the therapy: What do we need to do to solve the problem? And how do we do it? 

The 196 signatories of the 2015 Paris Agreement gave a common response to these questions, as they pledged to keep the rise in average global temperatures well below 2ºC compared to pre-industrial levels, and preferably limit the increase to no more than 1.5ºC. In order to get there, they committed to reaching net zero-emissions, to green the financial system and to provide technical and financial assistance to help developing countries in their adaptation and mitigation efforts.

According to the latest UN Emissions Gap Report (UNEP, 2021), “national climate pledges combined with other mitigation measures put the world on track for a global temperature rise of 2.7°C by the end of the century. […]To keep global warming below 1.5°C this century, the world needs to halve annual greenhouse gas emissions in the next eight years.”

This implies an annual decline of emissions slightly above 8% until 2030. If you consider that the decline of emissions in 2020, when the world economy shut down to fight Covid-19, was less than 6%, you see the daunting task we are facing.

Carbon pricing is the single most important instrument to get to net zero. Robust and predictable carbon pricing will generate incentives for shifting demand in favour of more sustainable goods and services and for redirecting investment flows towards low-carbon projects. 

Even if more countries are pricing carbon, cross-country differences are huge, emissions are still too cheap and coverage too limited, to foster a meaningful change of behaviour. The IMF estimates that to limit global warming we would need prices to rise from a global average of $6 per ton of CO2 today to $75 by 2030.

Furthermore, carbon pricing – however indispensable – is not enough to generate the massive reallocation of capital towards sustainable activities that needs to take place if we want to ensure a successful transition to a low carbon economy. 

 

2. Scaling up green finance – what is missing?

In order to address the climate challenge we need massive investment at global level.

Estimates of investment needs range from $3 trillion to $6 trillion per year until 2050, roughly 3 % to 6 % of (current) world GDP. The current level of green finance is estimated at about $630 billion – a fifth or less of what is needed – and very little goes to developing countries, where needs are greater. 

So what is preventing money from flowing to sustainable projects?

As mentioned, timid carbon pricing is a major impediment but, there are other hurdles blocking the reallocation of capital, and I would like to draw your attention to two of them.

One key impediment to larger volumes of sustainable investment is data. 

Financial market participants lack the data they need to assess projects, price climate and other environmental related risks and escape greenwashing.

The European Union, as well as several other multilateral institutions and fora such as the G20, the IMF, the NGFS (the Central Bankers and Supervisors’ Network for Greening the Financial System) have been pursuing an ambitious agenda to provide us with:

• Globally agreed principles for the classification of investments, such as taxonomies, labels and ESG-type ratings;
• An harmonised and consistent set of disclosure standards; and
• High quality, reliable and comparable data. 

We must step up these efforts, bearing in mind the need for scientific rigour and consistency among the different initiatives. Complexity must not go beyond what is strictly necessary: the aim must be to have reliable and comparable data at an affordable cost. 

The balance is delicate and the road ahead promises to be bumpy, as the recent controversies among defenders and opponents of ESG in the US illustrate so well.

A second major impediment to the redirection of financial flows to low carbon projects, which is particularly relevant in Europe, is the fragmentation of the capital market and the limited availability of venture capital. 

Whereas bank-based finance dominates the financial landscape in Europe, green investments have a number of features that call for venture capital, equity and blended finance. Indeed, green projects typically involve expensive and risky R&D, are highly capital-intensive and take a long time to mature. 

In a very interesting and illuminating recent paper, Philippe Aghion and co-authors conclude that a capital markets union with a strong equity component is instrumental to promoting green innovation in Europe. 

The authors argue that the reduction of carbon emissions to limit global warming to 1.5oC above pre-industrial levels requires the massive deployment of technologies that are not yet available, because the alternative – a massive reduction in consumption – is simply not feasible.  

They then develop a theoretical model that identifies the factors necessary for the development of new low carbon technologies, and conclude that the level of green innovation depends on three main factors:

• Carbon taxes to align private incentives with social goals;
• Government subsidies to spur green innovation; and
• A mixture between equity and debt investment.

It goes without saying that the resulting policy prescriptions for dealing with climate change - carbon pricing, subsidies to green innovation, capital market regulations - fall squarely in the realm of government policies.

Does this imply then that there is little left to be done by central banks and financial supervisors in the transition to net zero? 

That is certainly not the case, as I will try to argue in the third part of my talk.

 

3. How can central banks and financial supervisors help? 

There are three dimensions where central banks and supervisors, such as Banco de Portugal, can – and must – contribute to the net zero transition.

The first – and most impactful contribution we can make – is to deliver on our core mandates - to deliver price and financial stability throughout the transition to net-zero, thereby bringing much needed certainty to the process. 

This may sound to you like business as usual and lack of ambition – but it is far from it. 

In order to deliver on our mandates, we have to incorporate climate and environmental considerations into our policies and decision-making frameworks, which is in itself a more challenging endeavour than you might think.  

Climate change is an important source of risk for financial institutions essentially because the greater occurrence and severity of natural disasters and the transition to a low carbon economy have material impact on the valuation of assets financed by banks or covered by insurance companies. 

The Single Supervisory Mechanism – the arm of the ECB responsible for the supervision of euro area banks – has identified climate-related and environmental risks as one of its supervisory priorities for 2022-24, and we have all been working hard to: 

• Understand the financial risks stemming from climate change; 
• Assess the exposure and resilience of the EU banking system to these risks; and
• Adapt our supervisory instruments and policies in order to promote the resilience of the financial sector throughout the climate transition process. 

On the monetary policy front, and moving now to our mandate of maintaining price stability in the euro area, we also need to understand how climate change and the related adaptation and mitigation policies affect important variables such as credit, aggregate supply and demand and prices. In addition, of course, we need to protect our monetary policy portfolios from climate risk.

This is precisely the purpose of the action plan announced by the ECB a year ago. The first deliverable of this action plan came out just before the summer holidays, as the ECB announced that it would take into account the climate performance of the issuers of the securities purchased under its corporate asset purchase programme, or taken up as collateral for monetary policy lending. 

A second dimension where central banks have a duty to contribute is by decarbonising their own operations. This covers a large spectrum of areas, from the management of our large non-monetary policy portfolios, to banknote production, or the daily operation of our premises. 

On the occasion of COP26, in November last year, the Banco de Portugal committed to publishing by 2023, a roadmap to align its activities with the Paris 1.5oC trajectory and the EU climate goals for climate neutrality. Moreover, just a few months ago, we published a Responsible Investment Charter with principles guiding our reserve management operations.

Last, but certainly not least, central banks can play a critical role in raising awareness and contributing to advance knowledge on climate related matters.  

Central banks have a large pool of specialists on policy analysis and research and provide advice to governments in economic and financial matters. By giving more prominence to climate change or biodiversity in our research agendas, we contribute to more informed and effective environmental policies. We can also play a role through financial literacy and other knowledge sharing initiatives. 

Over the past three years, the Banco de Portugal has: 

• Extensively advised the government on issues related to the European climate agenda;
• Published research and analysis on the macroeconomic and financial impact of climate change and on optimal transition policies; 
• Taken part in the (ongoing) project of the Portuguese Environment Agency to assess the vulnerability of Portuguese territory to climate change in the 21st  century;
• Incorporated sustainable finance in the reference framework for financial literacy;
• Promoted or joined a significant number of outreach initiatives, such as this one, to communicate our positions and actions on climate issues.

 

Final Remarks

Allow me to conclude. 

It is an understatement to say that these have been challenging times for our economies and societies.

We were still fighting COVID-19, when another major shock, whose repercussions are still far from clear, hit the world economy, with a particular impact on Europe. 

Neither of these shocks should distract us from the far greater existential threat posed by climate change and biodiversity loss. 

We are no longer lacking awareness or scientific consensus. So what are we lacking?

I leave you with the very same question I left with your colleagues from the previous edition of this sustainable finance course: are we – each one of us - willing to change the way we live? Will we accept to pay much more for carbon-intensive goods? To alter our diet? To travel less? To buy less furniture, fewer clothes, fewer appliances, fewer gadgets? Are we willing to recycle more? To buy second-hand? To be serious about saving water and energy?

Are we actually doing this? Or, like going on a diet, is it something we’ll start tomorrow?

Let me stop here. Thank you for your attention. I will be happy to take on any questions or comments you may have.