Address at the opening lunch¹

 

Firstly, good afternoon to you all.

I would like to thank Clara Raposo and Sofia Santos for inviting me.

It is a great pleasure to be here and to participate in this opening lunch of the ISEG Sustainable Finance course.

Under normal circumstances, I would move straight onto the topic I was invited to address. Given the very sad, disturbing and also dangerous moment we are witnessing, I would like to start by expressing a word of deep and intense solidarity for the Ukrainian people. Through them I extend that word to all who are denied the right of living their life in peace in their own countries, something we have been taking for granted in Western Europe, but which clearly should not be taken as such.

Any topic seems to lose its relevance, when compared to the magnitude of the events going on in Europe but history has taught us that no matter how difficult and hard the situation might be, we’ve always been capable of overcoming it, even if sometimes at a tremendous cost.

So it is by trying to focus on the future that I hope this session can make more sense to all of you.

And when we think about the future, the environmental challenge ranks high, if not the highest, in terms of importance, sometimes translated into the expression “existential threat”.

To deal with this “existential threat”, the so-called “green transition” is clearly established and universally accepted as the way forward. But one thing is still lagging too far behind: to actually start acting in a decisive way, although there are promising signs coming from everywhere.

I believe it is worth mentioning that, since this is the third edition of the course you’re all about to start, it is already a good sign of how sustainable finance has become a critical topic.

What I thought would make more sense to bring to this session, and hopefully to help your digestion, is to try to offer a complementary view, and place the course’s contents into a broader economic perspective.

There is this very important rule which you all have probably heard,  which says “Less is more” and in order to stand by the rule, I plan to go briefly through three broad topics:

• The first is to recall that problems such as climate change, biodiversity loss or environmental degradation all have an economic root;
• The second is to discuss how to handle these problems, not by resisting to the threat they pose, but by making the most from the opportunities related to the transformation of our economies towards carbon neutrality, and of course it is in this part that the “sustainable finance course” mostly fits.
• My third and last point is to briefly share the central banks’ perspective on this topic namely what central banks can – and cannot – be expected to do about it.

So let me now move to my first point, which is, what I would call “The root of the problem”.

 

The root of the problem: Everything is economics!

And I have to start this point with two key assumptions:

One assumption is the recognition that climate change is the outcome of human activities. This is a science-based assumption, since it has been scientifically established, and beyond dispute, that environmental sustainability is under severe threat and such threat is due to global warming, biodiversity loss and pollution. All these  are largely the result of human activities.

The second assumption is that humans are not irrational, which means their behaviour is shaped by incentives and disincentives.

This brings to the fore the well-known expression “everything is economics”. Not in the sense that “economics” is all that matters, or that it matters more than other concerns of society and individuals, but rather in the sense that there tends to be an economic rationale behind every decision (or, at least, most decisions) made by individuals and organisations.

These two starting points are fundamental to understand, not just the root of the problem, but also the ways to handle it

And if we are serious about trying to solve the problem, understanding it is the key starting point, as happens when we feel sick and go to the doctor: he has to make the right diagnosis in order to prescribe the right medicine.

Elaborating a bit more on this topic, I would like to say that, from an economic perspective, the problem is quite straightforward.

We have billions of individual firms and consumers whose (decentralised) production and consumption decisions impose a cost on local communities, or on society as whole. This cost stems from CO2 emissions, deforestation, pollution or the depletion of natural resources.

As you know, this is what economists call “an externality”, which is an indirect cost (or benefit) imposed on an (uninvolved) third party that arises from another party's activity.

Firms and consumers do not pay, or do not pay enough, to compensate for the (negative) externalities caused by their activities and there’s no compensation either for those who produce positive externalities.

This leads to a situation where the private cost of most goods and services currently produced in the global economy is lower than their social cost.

The misalignment between the private and social value of production, leads us to produce and consume far more carbon-intensive or polluting goods than would be socially desirable, which consequently leads to the degradation of so-called natural capital, mostly because the market does not reward ecosystem services.

There aren’t many things economists are certain about, but one of such certainties is that in the presence of “externalities”, free markets do not yield efficient outcomes and we need corrective policies.

And this leads me to my second topic. Now that we know the root of the problem, how can we handle it, and if possible, how can it be turned into an opportunity?

Handling the problem without wasting the opportunity …

I start this second topic by quoting Mark Carney, the former Governor of the Bank of England: “Achieving net-zero will require a whole economy transition – every company, every bank, every insurer and investor will have to adjust their business models. This could turn an existential risk into the greatest commercial opportunity of our time."

Although new Covid variants can’t be fully discarded, if we look at economic indicators, it seems that the worst of the pandemic has passed and we are already well in the recovery process or at least we were, until a few days ago. In this context, it would be extremely important to seize the opportunity of the recovery in order to embark on – and accelerate - this “whole economy transition”.

One key question that stands is how can we ensure the recovery is green, not just on the surface, but also deep inside?

To answer to this question positively, we need two things (much easier said than done!):

• We need to put in place the right policies;
• And we need to finance the transition.

By the “right policies”, I mean policies that create the right incentives, to reconvert production, alter consumption patterns, preserve ecosystems and, to reallocate savings towards sustainable activities.

In this context, carbon pricing is the single most effective instrument to deal with climate change:

To ensure the market provides the right signals to producers, consumers and investors, the very first thing we need to do is to discard fossil fuel subsidies and to charge the right price for carbon emissions. By “We” I’m not just referring to Portugal, I’m referring to coordinated global action.

To give you an order of magnitude of what I am talking about, according to IMF estimates, fossil fuel subsidies are equivalent to more than 5 trillion US dollars annually.

To comply with current emissions reduction targets, we would need an average global price of 75 USD per ton of CO2 by 2030, up from the current 3 USD per tone, which covers only about one fifth of global emissions.

If carbon pricing is key to reducing CO2 emissions, when we think about the fight against the loss of biodiversity, then we should also ensure that ecosystems not only become an important source of income for those who preserve them, but also that the healthier the ecosystems, the higher the income. This implies finding ways to bring income to those who preserve natural capital ... and also to charge those who use it.

And this is a topic where a country like Portugal could have much to gain.

Our vast exclusive economic zone provides critical biodiversity services and has a huge potential for carbon capture, which can be an important source of revenue in the context of a well-functioning carbon emissions market.

In addition to pricing carbon emissions or the use of natural capital, other policy instruments can also play an important (even if complementary) role. I’m referring to environmental regulations, public investment in R&D and in green infrastructure, or even subsidies for clean energy.

The key challenge lies in the fact that these policies have massive distributional consequences both within and across countries, and it is often the most vulnerable households and the poorest countries that suffer the most.

The Gillets Jaunes movement in France and the protests in several countries following the rise in energy prices clearly showed there is no way around this. We need fair compensation measures to make sure decarbonisation policies are (politically) feasible.

In addition to the right policies, if we want to extract the most from the opportunities offered by the imperative to decarbonise the economy,we must also be able to finance the transition.

And on the topic of “financing the transition” I would like to share three very brief notes.

The first note is about the volume of finance needed.

To say the green transition implies a very substantial amount of additional investment is clearly an understatement as we’re talking about both public and private investment that needs to be deployed over several decades.

The European Investment Bank estimates that in order to reach its climate target of a 55% decline in emissions by 2030, the EU will need additional investment of 2.1% of GDP each year for the entire current decade.

This extra-investment is both a challenge and an opportunity, since it will help innovation, growth and jobs.

According to the IMF, a policy mix of carbon taxes and green investment stimulus could increase the level of global GDP in the next 15 years by about 0.7 percent and create around 12 million new jobs by 2027.

The second note I would like to share is about the instruments that need to be used to finance the transition.

Sustainable investment projects typically involve new technologies and significant R&D costs. They also tend to be capital intensive and have very long implementation horizons.

The characteristics I’ve just mentioned are not properly dealt with by traditional bank loans and bonds, which are the predominant instruments in the European financial landscape

We will definitely need other instruments as sources of finance such as equity, quasi-equity or venture capital.

Again, this challenge can be an opportunity to substantially expand market-based finance throughout the EU and particularly in Portugal.

My third and final note is about data.

The green transition cannot be achieved by delegating to a central authority the extreme power of defining where we can or cannot invest.

Achieving this goal has to rely on the capacity of those who invest being able to make the right choices. For this, investors need to be able to assess the risks, the expected returns and the ESG credentials of alternative investments. And all this requires good data.

Lack of data has been a key obstacle to implementing sustainable investment strategies and measuring progress towards a greener economy.

To handle this obstacle, there are promising avenues, such as classification systems, labels, harmonised reporting standards and, external verification requirements.

But it is also fundamental to ensure transparency and a broad coverage, otherwise, we might end up with a situation that was addressed in a recent article in “The Economist”.

The Economist reported that “dirty assets are heading into the shadows”. This is because listed firms are selling their most polluting assets to meet their carbon reduction targets, but these assets continue to operate in the hands of more opaque organisations (who may even increase production!).

To wrap-up this second topic, I believe it’s fair to conclude that the financial sector and financial policies play an irreplaceable role in the transition to a sustainable economy. That is because the energy transition will only be possible if the financial system is able to finance the tremendous volume of (green) investments, which will be needed over the coming decades. And for such financing to occur, the lending decisions have to reflect a fair assessment of environmental risks.

This brings me directly into the third and final topic I would like to address today which is how can central banks help?

 

Central banks: action drivers and boundaries!

To start this third and final topic, I would like to share another quote, but this time from the former Governor of the Bank of Japan, Masaaki Shirakawa: “… central banks always have to be aware where they can best contribute to a sustainable economy. For me it is price stability and financial stability where central banks have a comparative advantage.”

It is clear from what I said before that environmental concerns must be addressed, first and foremost, by the political authorities who conduct economic policy, because the root of the problem is essentially economic.

However, it also goes without saying that the central banks need to contribute because their core missions are significantly affected by climate change and energy transition. One of the most important missions, if not the most important, is to preserve and reinforce financial stability, which is a pre-requisite for an economy to function properly, for all economic agents, be it individuals or companies, being able to take their decisions of consumption, saving and investment.

For this to happen, central banks are required to promote the resilience of the financial sector throughout the transition towards a carbon neutral economy. This means that central banks must assess and deepen their understanding of climate-related financial risks in order to properly manage them.

As far as the Banco de Portugal is concerned, this has been an important item on our agenda for the past three years.

A few months ago, we published a study that quantifies the Portuguese banking system’s exposure to firms more sensitive to the transition to a low-carbon economy.

The results suggest that around 60% of banks’ exposures to non-financial corporations are in climate policy-relevant sectors, especially in the construction and real estate sectors, and to a lesser extent in transport and energy-intensive industries.

We are also upgrading our prudential framework to encourage financial institutions to measure and price environmental risks.

The ECB has set supervisory expectations on climate-related and environmental risks for the larger euro area banks and Banco de Portugal has extended these expectations to the less significant institutions, which fall under our direct supervision.

Besides safeguarding financial stability and maintaining price stability, central banks can also use their analytical capacity to contribute to the transition to a more sustainable economy.

Although it’s up to governments to implement economic policy, our mandate as a central bank, includes providing advice to the government on economic and financial issues. In this capacity, we have contributed to shaping multiple sustainable finance initiativesand we published research on the effects of climate change, in order to inform public policies and society as a whole.

Concluding remarks

Let me conclude by saying that very few global challenges were able to remain under the spotlight during the pandemic as the climate emergency.

This means that climate emergency is here to stay, even if other events take the centre stage in the media and in our attention, as is the case of the situation currently developing in Ukraine.

Bearing this in mind, we cannot afford to miss the opportunity of setting in motion a virtuous cycle of investment, growth and environmental sustainability.

The big question that remains is to know whether we are willing to bear the cost of the green transition when confronted with the need to pay (much) more for the carbon-intensive goods we consume? In other words, whether or not we are willing to change the way we live?

One last word to say that after I started preparing the messages to share here today, I happened to listen to Vivaldi’s Four Seasons.

As I was listening to it, I wondered whether he would have been able to compose such a masterpiece and to name it that way if he had lived three centuries later, in our time, given the impact of climate change.

I stop here, leaving you with this open question that combines hope with a dose of scepticism.

Thank you again for the invitation and I am happy to take any questions or comments you may have.