Cop27: what are the implications for central banks and supervisors?

December 1, 2022|Written by Jeremy McDaniels
A family sit on top of their house roof, which is surrounded by floodwaters
An agreement on loss and damage for poorer countries is seen as a big achievement but many questions about implementation remain © Muhammad Amdad Hossain / Climate Visuals

In the same form as Cops past, this year’s meeting of the UNFCCC parties had mixed results. While the Sharm el-Sheikh Implementation Plan does encapsulate some notable successes, including financing for climate-vulnerable countries, progress at Cop27 on several items – including greater ambition on phasing down fossil fuels – fell critically short.

Looking at the negotiation outcomes, central banks and supervisors are likely face an array of questions as they develop responses to climate change into next year, including approaches to addressing interlinked risks over long timeframes, managing uncertainties in the ambition and speed of government policy, and implications of broader monetary and financial market conditions for transition investments.

Unpacking the agreement on loss and damage

Perhaps the key legacy of Cop27 is the establishment of a new financing mechanism to compensate vulnerable countries for loss and damage inflicted by climate change, heralded by many stakeholders as a significant breakthrough. Carefully worded, the agreement in essence formalises the legitimacy of long-standing calls for financial reparations for current and future climate damages in vulnerable countries, stemming from the historical emissions of developed countries.

Specifically, section six of the implementation plan “welcomes the consideration, for the first time, of matters relating to funding arrangements responding to loss and damage associated with the adverse effects of climate change, including a focus on addressing loss and damage”.

The implementation plan and other outcome documents provide a schematic of a mechanism through which developed countries will contribute to a fund that will be used to finance recovery from, and resilience to, both acute climate events (such as extreme weather) and slow-onset climate impacts (such as desertification).

However, many critical open questions have been allocated to the new transitional committee which is expected to meet for the first time in early 2023. These include responsibilities for oversight of the fund, how funds will be distributed and which countries or climate disasters will merit compensation. It remains to be seen if two pressing issues – which countries should pay into the fund and how much different countries should contribute – can be resolved in advance of Cop28.

Critical gaps remain on plans for reducing emissions

Additional funding to pay for the climate damages will only make a material difference for the resilience of vulnerable countries if levels of funding match the costs of damage. A lack of progress on critical global emissions reductions targets necessary to keep the 1.5ºC goal alive were absent from the final text. These include progress on global emissions peaking before 2025, clearer plans for phasing down coal and a high-level commitment to phase down other fossil fuels.

The lack of strong follow through on last year’s negotiation outcomes in Glasgow, which were praised as successes, has meant that Cop27 has not contributed to bending the curve of emissions down towards the steep trajectory implied by meeting the 1.5ºC or even 2ºC target.

Any evaluation of goals from the Cop meetings must consider the variety of factors that may affect its credibility, including domestic political factors affecting the scope and speed of national implementation, as well as broader geopolitical and macroeconomic conditions.

Looking across all of these factors, it is clear that climate ambition and multilateral collaboration are facing greater headwinds than have been experienced for decades. As such, it is perhaps unsurprising that the “homework” assigned to countries at Glasgow – in terms of more ambitious near-term plans for emissions reductions by 2030 – was not completed by most negotiating parties. Promises to update nationally determined contributions were only delivered by 24 countries in advance of Cop27, and by none of the largest emitters.

The same issues of implementation credibility are especially salient when it comes to multilateral climate finance. Progress on loss and damage may have strengthened trust in the multilateral process for vulnerable countries. But repeated under-delivery of existing climate finance commitments (including the $100bn goal set at the Paris meeting in 2015) suggests that contributions into the new fund, which may dwarf existing climate funding allocations, will not come easily. A lack of clear progress on other financing structures, including the New Collective Quantified Goal on Climate Finance, illustrates the challenges ahead.

The changing role of central banks and supervisors

Lack of progress at Cop27 on clearer global and national-level emissions reductions pathways will require central banks to take a broad view of possible climate futures, and potentially reconsider base case scenarios for future climate change.

 

A person stands on a mountain ridge, looking at the far slope which has been cleared of trees
Progress at Cop27 on reducing emissions, such as those caused by deforestation, was limited © Francis Eatherington

The world continues to head for 2.4ºC of warming (with a range of 2.1–2.9ºC), nearing the realm of the hothouse world scenario outlined by the Network for Greening the Financial System (NGFS). Taking a view that a hothouse world may be the most likely scenario could raise important strategic questions for central banks, including in jurisdictions where there is debate regarding the mandates of central banks in responding to long-term risks.

If central banks begin to calibrate policy responses to both near-term climate impacts within supervisory time horizons, but also potential longer-term impacts for which mitigation actions are required to today, this could potentially trigger decisions to apply prudential and supervisory tools to respond to risks in ways they were not initially designed for. Inadequate government policy responses could lead to greater stakeholder pressure for more ambitious action by central banks, notwithstanding the risks and potential unintended consequences of using prudential and supervisory tools to incentivise financial institution behaviour.

Statements in the implementation plan regarding the need for a transformation of financial architecture, including potential reforms to multilateral development banks and international financial institutions, could have broad-ranging implications for central banks if current levels of inflation and volatility persist. Central banks may need to broaden and deepen work on the macrofinancial dimensions of the low-carbon transition, including the implications of rising interest rates and tighter financial market conditions for capital reallocation towards low-carbon sectors.

It is too early to assess whether the agreement on loss and damage may affect central bank responses to climate change, considering that any such impacts are contingent on implementation. Central banks in vulnerable countries are likely to face an array of monetary policy challenges as climate impacts mount.

Progress on loss and damage would need to enable material contributions to resilience to avert impacts on sovereign credit, including adaptation investments in the most-exposed regions. If key thresholds such as the resilience of critical infrastructure are crossed, central banks are likely to face increasing challenges if heightened risk profiles due to climate change constrain foreign investment.

Emerging as new priorities for 2023 are oversight of net-zero alignment within the financial sector, efforts to support enabling conditions for climate investment, and exploration of the interactions between climate and nature-related risks. The array of private-sector sustainable finance announcements alongside Cop27, including multiple different pieces of guidance for financial sector transition planning, has created an imperative for consolidation.

Official sector leadership coalitions, including the Coalition of Finance Ministers for Climate Action, appear to be ready to enter the ring on net-zero transition planning at an economy-wide level. This could potentially enable central banking coalitions such as the NGFS to focus more closely on supervisory responses within the financial sector.

Looking more broadly, more central banks may begin exploring their role in areas such as blended finance, which may enable the development of new pathways for integrated policies aimed at encouraging capital allocation towards the net-zero transition through monetary and supervisory means.

Finally, central banks may increase focus on the financial risks associated with nature loss, reflecting the increasing recognition of the interlinkage between climate resilience, mitigation, and protection and restoration of natural capital. In this area, Cop15 of the UN’s Convention on Biological Diversity – which is hoped to deliver a “Paris Agreement for nature” – stands as another very significant milestone for central bank action on both net zero and biodiversity.

This page was last updated December 1, 2022

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