Climate-Related Financial Policy in a World of Radical Uncertainty: Towards a Precautionary Approach

Abstract

Climate-related financial risks (CRFR) are now recognised by central banks and supervisors as material to their financial stability mandates. But while CRFR are considered to have some unique characteristics, the emerging policy agenda for dealing with them has largely focused on conventional market-based solutions. Current policy emphasises information gaps that prevent the accurate assessment of market risk. The assumption is that these gaps can be remedied via disclosure, transparency, scenario analysis and stress testing, which will enable markets to self-correct. We argue this approach is misguided as CRFR are characterised by radical uncertainty and hence ‘efficient’ price discovery is not possible. Instead, a ‘precautionary’ policy approach is proposed. Since climate change poses a severe and potentially irreversible threat, lack of scientific certainty as to its exact nature or timing should not prevent regulatory action to mitigate its impact. Such an approach justifies fully integrating CRFR into financial policy, including both prudential and monetary policy frameworks. Central banks and financial supervisors can and should actively steer market actors in a clear direction — towards a managed transition — to ensure a scenario that minimises harm to the financial system and the wider economy in the future.

Keywords: Financial stability, financial regulation, macroprudential policy, central banks, climate-related financial risks, climate change, sustainable finance, systemic risk, low carbon transition

JEL Classification: Q54, E44, E58, G28, G18, G14