The Next Big Financial Crisis Could Be Triggered By Climate Change – But Central Banks Can Prevent It

Climate-stress-testing banks

First, regulators can require banks to publicly disclose their risks from climate change and stress-test their ability to manage change.

The Biden administration recently introduced an executive order on climate-related financial risk, with the goal of encouraging U.S. companies to evaluate and publicly disclose their exposure to climate change and to future climate policies.

In the United Kingdom, large companies already have to disclose their carbon footprints, and the U.K. is pushing to have all major economies follow its lead.

The European Commission also proposed new rules for companies to report on climate and sustainability in their investment decisions across a broad swath of industries in its new Sustainable Finance Strategy released on July 6, 2021. This strategy builds on a previous plan for sustainable growth from 2018.

Carbon disclosure represents a crucial ingredient for “climate stress tests,” evaluations that gauge how well-prepared banks are for potential shocks from climate change or from climate policy. For example, a recent study by the Bank of England determined that banks were unprepared for a carbon price of US$150 per ton, which it determined would be necessary by the end of the decade to meet the international Paris climate agreement’s goals.

The European Central Bank is conducting stress tests to assess the resilience of its economy to climate risks. In the United States, the Federal Reserve recently established the Financial Stability Climate Committee with similar objectives in mind.

Monetary and financial policy solutions

Central banks and academics have also proposed several ways to address climate change through monetary policy and financial regulation.

One of these methods is “green quantitative easing,” which, like quantitative easing used during the recovery from the 2008 recession, involves the central bank buying financial assets to inject money into the economy. In this case, it would buy only assets that are “green,” or environmentally responsible. Green quantitative easing could potentially encourage investment in climate-friendly projects and technologies such as renewable energy, though researchers have suggested that the effects might be short-lived.

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Disclosure: This article is republished from The Conversation under a Creative Commons license.

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