“The primary responsibility for managing the transition to a low carbon economy rests with the elected governments. However, if it is true that climate change is indeed “the greatest and widest ranging market failure ever seen”, a smooth low-carbon transition will require the implementation of a comprehensive set of policies, some of which might involve the collaboration of central banks and financial regulators.” 

(Campiglio, E. et al (2018), “Climate change challenges for central banks and financial regulators”, in Perspective, Nature Climate Change, Vol 8, June 2018, pp. 462-468) 

 

1.Introduction 

I would like to thank Mr Paulo Soares de Oliveira for the kind invitation to join you today. Also, allow me to salute this morning’s speakers as well as all participants that have joined us today, either present here or watching via live streaming.

It is a great pleasure to open this PSO-sponsored event, on the topic of sustainable finance and the risks and opportunities it poses to the Portuguese financial system. This topic is one of the few which can compete, in terms of attention and importance, with that other topic which has caught us by surprise and taken root since the beginning of the year, only to obstinately remain the centre of attention.

Before I move on, I have an important clarification related to the concept of ‘sustainability’. This concept covers several components, which have been aggregated into three factors, mirrored by the ESG acronym (Environmental, Social and Governance). In the scope of this conference and my address, I will focus on one component only (the environmental component) and, within it, climate change, as the main determinant of sustainability.

I have structured this address in such a way as to fit in my 20-minute window, which implied prioritising breadth (however brief) over depth.

I will start by making it clear where we are starting from, that is, what can be deemed the root cause of the problem we face when we discuss ‘sustainability’ or ‘climate change’.

It is key to show clarity in this ‘prime’ aspect of the problem, as this is a prerequisite to help establish who must act to deal with it and how they must act. This is not “passing the buck”: the point is simply to help ensure that everyone does their part, bypass incorrect assumptions and, therefore, minimise the possibility of overlapping action in some areas, while others have considerable gaps.

Next, in my address, I will try to synthetically elaborate on the financial system, ie:

• Why is this a pressing topic for the financial system?
• What are the main aspects that must be considered when addressing this topic, including that of central banks as supervisors and, albeit to a lesser extent, also regulators, of the financial system and, particularly, the banking system?

I will also try to share some information focused on the Banco de Portugal’s approach to these matters. And I will conclude with a few ideas or key messages worth bearing in mind.

 

2.Getting to the root of the problem

Surely, the overwhelming majority of those present have come across the expression “everything is economy”. And although it may sound like an overstatement, a closer look removes any concerns regarding a possible hyperbole. Indeed, the topic discussed here today is yet more proof that this is not an overstatement.

This expression mirrors the fact that behind every decision made by both individuals and organisations there is an economic rationale.

Decisions made by individuals may be simple, with little or no impact on those around us, such as, for instance, the option of sleeping in for an extra 15 or 20 minutes in the morning or of getting up without that extra time of slumber. While this may sound odd, there is an economic rationale behind this decision. It concerns each person’s assessment of the benefit they reap from those extra 20 minutes of sleep vs. the benefit that they draw from those same 20 minutes, if they are up and about, that is, the “opportunity cost”.

One such decision will impact only the decision-maker and, as such, has no consequence on others around them, which means that it does not bring about what economists refer to as ‘externalities’ and, if it does, they will most likely be negligible. At the other end of the economic relevance spectrum, and due to the externalities it entails (as well as its opportunity cost), is the topic we will be discussing today.

At the root of the sustainability issue and the pressing need to address it is, in all likelihood, the largest worldwide mis-pricing phenomenon in living memory, to the extent that its negative externalities (stemming from the environmental impacts of several activities) have not yet been correctly incorporated into the prices of products and services charged by the various economic agents. This means all those who carry out such activities, those who incorporate them as intermediate products or services, those who act as final consumers, but also those who fund such activities.

If we believe that this is the main problem, then its solution must entail the adjustment of relative prices separating products and services with a negative externality from those with no such externality. And when we talk of changes to relative prices, this means, making some prices more expensive against others, which is clearly a matter that mostly falls within the jurisdiction of whoever makes economic and tax-related choices.

However, this does not mean that in this path of adjustments to the prices of products and services, there is not also a major role to be played both by the financial sector and the supervisors and regulators of the financial sector, in general, and the banking sector, in particular.

This bring us to the following item in my address.

 

3.Going into why this topic is relevant to the financial system and central banks

I will endeavour to flag three aspects that make this topic particularly relevant to the financial system and central banks in particular:

• The first is financial stability, which is strongly connected to the mandate of central banks and has implications for the entire financial system as well as the non-financial sector. Further on, I will elaborate on this. 
• The second aspect regards monetary policy. While monetary policy is the responsibility of central banks, with very profound implications for economic agents, anything that may impact on its proper functioning is always a matter of major concern for central banks.
• The third is the strategic dimension that sustainability concerns have been gaining in a growing number of members of the central banking community, mirroring developments in the corporate sector.

 

4.Aspect 1 – Financial stability

We have been witnessing growing developments in both the visibility and predictability (in the sense that they are more and more expected) of the effects and risks associated with climate change, at least in qualitative terms. These risks are typically classified under two major categories:

• Physical risks, related to the greater frequency and intensity of natural disasters (droughts, floods, fires, hurricanes, etc.) and to the consequences of environmental degradation (pollution, ocean acidification, increase in temperature, loss of biodiversity, etc.); 
• And transition risks, associated with the (unavoidable) adjustment to a ‘greener’ economic system and society, and due to regulatory or tax changes, technological developments, changes in consumer preferences, or even the increase in litigation. 

Great uncertainty still surrounds the quantification of these impacts, the determination of the time horizon in which the associated costs will take place and will be calculated. However, despite this uncertainty, there are few people who doubt whether climate change produces non-linear effects, often irreversible, which go beyond national borders and entail huge costs. 

It is also acknowledged that costs are asymmetrical across countries, regions and even sectors of activity, given that the magnitude and distribution of the impacts are conditional on several factors, such as:

• The degree of exposure to environmental risk and the degree of resilience of the country, region, or sector of activity or even of a specific company;
• The mitigation and adaptation measures eventually adopted by the competent authorities (and their timing);
• And the response of economic agents.

Due to the aforementioned factors, it can be concluded that the climate change phenomenon is a relevant issue to the financial system, at two key levels.

On the one hand, environmental risks are a source of financial risk, to the extent that both physical and transition risks tend to spill over into the availability and valuation of assets which are funded or used as collateral by the financial system. These risks must, therefore, be reflected in the types and prices of funding transactions. We have often heard defend that subsidies be granted to “all things ‘green’”, but the line taken by Banco de Portugal is that the price of funding should accurately reflect the associated risk.

On the other hand, the transition to a ‘greener’ economy implies a very sizeable volume of investment in the course of several decades, and as this investment does not “arise spontaneously”, it must be funded. To meet the purpose set by the European Union of reaching carbon neutrality by 2050, in net terms, this would mean additional investments in the range of 175 to 290 billion euro per year (equivalent to between 1.1% and 1.8% of the EU’s GDP). 

If we consider the constraints in terms of savings, indebtedness, risk appetite, it does not require much effort to imagine how much this topic is of particular importance to a country like Portugal and its financial system.

Given the amounts of financial resources needed and the different ways in which they must be applied, the levels of investment needed to reach carbon neutrality will only be achievable if three conditions are met:

• A combination of public and private investment;
• A combination of traditional financing and other modalities (equity, quasi-capital, venture capital, ...);
• That the financial system, as a whole, plays its proper role in channelling financial flows to the so-called ‘green’ investment. And it is not enough to be dyed green, it must be ‘inherently’ green!

It is not difficult to understand how much of a business opportunity this increased demand for funding is for the financial system.

But this opportunity also poses hefty challenges: 

• On the one hand, this means financing investments with a very substantial potential for accelerating technological progress and creating value;
• On the other hand, the difficulties concerning the calculation of risk premia on this type of investment and the adequacy of financing instruments pose challenges which financial operators cannot overlook.

Financial institutions which retain, in their balance sheet, the risk of investing the resources at their disposal must ensure that the price that they charge for the financing operations properly reflects the degree of sustainability of the asset underlying that investment. 

The cost of financing cannot merely cover the traditional market risks associated with competition and technological developments and must also take into account environmental risks.

Environmental risks, in turn, are conditional on the timeliness and efficiency of the regulatory and tax measures that may be taken as a response to the climate challenge, as well as possible structural changes in supply and demand, which, on the other hand, stem from the increased sensitivity of consumers to environmental matters and the growing scarcity of those natural resources. 

A calculation of profitability that disregards environmental risk over the time horizon relevant to the investment of resources will almost inevitably tend to overestimate the feasibility of the investment.

Guaranteeing that risks are properly assessed, either to prevent an excess build-up or to ensure that capital buffers are adequate, to be able to ensure resilience should risks materialise, is a concern directly connected to a key mandate of central banks and supervisory authorities, that is, the maintenance of financial stability.

Safeguarding financial stability does not mean preventing bankruptcies or losses, but rather ensuring that, should they occur, they can be absorbed without jeopardising the functioning of the system as a whole.

However, as in many other situations, in this case it is also “easier said than done”, and many obstacles must be overcome to enable and encourage, in practice, this internalisation of environmental sustainability costs in the pricing of transactions. These obstacles may be grouped into two major categories.

• One is due to the lack of granular information, at corporate level, that is reliable, comparable and makes it possible to build benchmarks and classify the nature and risk of investments. The small quantity and low quality of data limit information made available to investors and the financial markets, which results in lack of transparency and information asymmetries, thus hampering the development of sustainable finance. 

However, we must acknowledge the progress that has been made in this domain, such as the release in mid-2017 of the Recommendations of the Task Force on Climate-related Financial Disclosures and, more recently, the adoption of the European regulation to facilitate sustainable investment, also known as the “Taxonomy Regulation”. This regulation, which was approved in June and should be fully operational by 2022, lays down criteria to determine whether an economic activity is environmentally sustainable, thus making it possible to gauge the degree of sustainability of a given investment.

• A second challenge stems from the very nature of the sustainable investment projects. Such projects often involve innovative technologies and governance models, entail substantial I&D costs, are highly capital-intensive, pose high risks and have very long materialisation horizons (10, 20 or even 30 or more years).

The development of bond and credit markets geared towards green finance will not therefore suffice to meet demand, also because many of the projects in question are not the best suited to debt financing. Rather, and as stated above, many projects require additional financing instruments, such as equity, quasi-equity or venture capital instruments.

 

5.Aspect 2 – Monetary policy

I shall be very telegraphic here. As I have said, the risks related to climate change translate into financial risk and are therefore the object of attention by the authorities responsible for preserving financial stability. 

In addition to preserving financial stability, another key component of central banks' mandates, which can be particularly impacted by both climate change and the corresponding mitigation measures is monetary policy.

Here, I would just like to stress that the point of contact for sustainability with monetary policy, is directly related to the fact that climate change and the corresponding mitigation and adaptation policies, will have a relevant impact on supply and demand. That impact is likely to influence the neutral interest rate and the monetary transmission mechanism, thereby affecting the conduct of monetary policy. Given the importance of monetary policy, which I believe has been very visible to all, no central bank can neglect any aspect that might impact the functioning of that monetary policy.

 

6.Aspect 3 – Central banks’ strategy

The third and final aspect I would like to refer, also in a telegraphic way, is that central banks and financial supervisors, besides having to pay increasing attention to sustainability, due to its impact on the two core areas of their mandates - preserving financial stability and the conduct of monetary policy - are also following the path of other entities, from the financial sector and beyond, to incorporate in their strategic plans and their day-to-day management the ESG - Environmental, Social and Governance parameters. Indeed, as organisations having an impact on the environment themselves, they want to do their part and make their contribution and, in this way, also set an example.  

The cross-cutting and supranational aspect of these concerns led to the creation, in December 2017, of the so-called NGFS - Central Banks and Supervisors Network for Greening the Financial System, which aims to define and promote good practices in the management of environmental risks in the financial sector and support the transition to a more sustainable economy. The Network currently has 69 members and 13 observers from around the world, including the Banco de Portugal, which joined in December 2018. 

I would like to take this opportunity to stress that having been connected to the business world where competition is the name of the game, it is indeed a privilege to note that the Central Banks and Financial Supervisors community has a remarkable ability to share information and to cooperate in a very open and committed manner.

And this brings me to the last point that I wanted to share with you before concluding.

 

7.Going more specifically into what the BdP has been up to

The Banco de Portugal could not be oblivious to concerns about sustainability and sustainable financing. 

"Banco de Portugal's Commitment to Sustainability and Sustainable Financing", released last March, frames the Bank's response to sustainability challenges (in particular, those arising from climate change) and sets out four action plans:

• The identification and assessment of climate-related risks;
• The adoption of internal sustainability practices;
• Participation in national and international fora; and, finally,
• Communication and collaboration with other entities.

Going into more detail on each of the action plans I mentioned before.

First, we have integrated the identification and assessment of climate-related risks into our research agenda, and several research projects are in progress. In this context, I would like to highlight two studies, which are in the process of being completed and which we hope to release soon:

• The first study seeks to assess the Portuguese banking system's exposures to non-financial corporations in relevant sectors from the standpoint of climate change, with the objective of identifying the banking sector's vulnerabilities to the transition to a low-carbon economy. We believe that it is critical to be well aware of the risks that are already present in the balance sheets of financial institutions, due to their exposure to the sectors most severely impacted by the energy transition (increase in carbon price).
• The second study addresses the geophysical, technological, and economic aspects of climate change and economic policies to mitigate its effects.

We hope and wish that these studies will make a positive contribution to "fact based decisions" and hopefully "good fact based decisions".

Our second action plan is the implementation of internal sustainability practices, namely in the management of the Bank's asset portfolio and the reduction of the Bank's ecological footprint as an organisation. 

About a year ago, the Bank incorporated the ESG principles into its own investment asset management guidelines, and work is currently underway to implement the new rules. Given the size of the BdP Balance Sheet, it is clear how important these guidelines can be in resource allocation in the investment portfolio.

Already this year, by the end of January, the Bank joined the Lisbon Green Capital 2020 Commitment, an initiative of the Lisbon City Council, under which the Bank has committed to take, by 2030, 10 actions in four key areas to combat climate change, i.e., energy, water, circular economy, and citizenship.

In early September, we have signed a partnership contract with the Portuguese Environment Agency, the Directorate-General for Territory, the Faculty of Sciences of the University of Lisbon and the Portuguese Institute for the Sea and Atmosphere for a roadmap on adapting to climate change in the 21st century in Portugal.

The third priority action plan we have set concerns the bank's intervention in national and international fora where measures with potential impact on the financial system are discussed. This is a field where much has happened, and on different "stages". 

At the international level, the Banco de Portugal currently comprises 12 working groups, committees and other sub-structures specifically focused on this issue, within the European Central Bank, the European Systemic Risk Board, the European Banking Authority, the Bank for International Settlements and the aforementioned Central Banks and Supervisors Network for Greening the Financial System. 

And our "integrating working groups" concept is not just about being there to listen to what other people say, although this is also important. A key element of this participation is the highly active contribution in order to include in the discussion aspects that are relevant to our economy and our financial system. We must bear in mind that it is in many of these working groups that guidelines are prepared to be incorporated into the rules established at European level and applied to each of the EU member states.

In a context where the rules under which we operate are increasingly set at European rather than national level, we need to be able to follow-up and monitor everything that can impact us through a supranational regulatory approach, aiming to avoid negative impacts and, if possible, influence decisions so that they can be positive for the economy and for the country as a whole.

At domestic level, the Bank takes part in a think tank on Sustainable Finance (Grupo de Reflexão para o Financiamento Sustentável-GRFS), a group coordinated by the Ministry of Environment and Climate Action, and which comprises the three financial supervisors, financial sector business associations and various financial institutions.

Finally, the Banco de Portugal’s fourth and last action to address sustainability challenges is communication and cooperation with external entities, and covers the establishment of contacts, networking, and the implementation of disclosure initiatives. In this field, the Bank has participated in various conferences and seminars, published articles in specialised magazines and cooperated with the media.

 

8.Conclusion

To conclude, I would like to highlight three key ideas:

• The concern for sustainability, particularly in its environmental aspect, poses huge, complex challenges, but also tremendous opportunities not to be ignored by the financial system;
• Environmental risk and the transition to a higher level of sustainability are a source of financial risk and have structural implications on both supply and demand, which puts this issue at the centre of central banks' and financial supervisors' attention because of their implications on two crucial areas of their mandates, financial stability and monetary policy implementation. To this extent, central banks, financial supervisors, and the financial community in general cannot ignore sustainability issues.
• Sustainable financing is a prerequisite for a successful transition to a "greener" economy and society, but it does not replace the need for a comprehensive and coherent environmental policy on the part of the executive branch of government, as responsible for economic and fiscal policy options. Economic agents are rational. They need, above all, the right incentives, and disincentives, to align their behaviours with maximisation of usefulness for the society, and the achievement of this alignment falls within the scope of economic and fiscal policy initiatives. 

I conclude by thanking PSO once again for inviting me to be here today, wishing you an excellent and fruitful morning's work and suggesting an image to inspire you in many important decisions lying ahead.

The good news is that we do not need to cross borders to see this image and get inspired, just go to the INE (Statistics Portugal) website, and read what is written on the stained-glass window by Abel Manta, a Portuguese artist. The sentence is written in Latin (Ad divitias per scientiam nvmerorvm) which in English means “... prospering by getting acquainted with numbers  ...”. What the Anglo-Saxons call “fact based decisions”

Good morning and thank you very much!