New macroeconomic tool proposed to address climate risk

October 31, 2023|Written by Scott Speer

A new loan-to-value macroprudential tool has been proposed by Finance Watch in its latest report, Finance in a Hothouse World.

The loan-to-value tool would see a capital surcharge being triggered once a certain threshold of climate-related risk is reached. The loan-to-value threshold would be set in proportion to the amount of fossil fuels a bank is exposed to that can be safely exploited within the carbon budget for a given temperature increase.

According to Finance Watch, the tool has been used in the real estate market, proving effective at managing risks and improving the quality of mortgage loan portfolios and bank capitalisation.

“Limits like this have improved the probability of default on loan repayments, as well as the financial loss for a financial institution if a borrower defaults,” the report says.

The report also says that 97% of the world’s fossil fuel reserves would have to be left in the ground if humanity wants to limit global warming to 1.5°C with an 83% probability.

The new proposal is a response to the failure of European financial institutions to back an earlier microprudential solution proposed by Finance Watch in 2020. The one-for-one rule that banks and insurers must hold one euro for every euro used to finance new fossil fuels as a way to be held liable for potential losses.

The climate flaws in economic modelling

In addition to providing recommendations on macroprudential policy, the report analyses how climate change is factored into economic modelling. With Cop28 only one month away, Finance Watch says it is “sounding the alarm on the severe disconnect between climate science and economic modelling shaping economic and financial policy”.

In July, a landmark report by the Institute and Faculty of Actuaries and the University of Exeter found numerous “implausible” outcomes when analysing how financial institutions forecast the economic impact of climate change.

Thierry Philipponnat, chief economist at Finance Watch, said: “Economists analysing the impact of climate change must not be complicit, even if unwillingly, in the inaction of policymakers. They have a responsibility to open their eyes to the economic and financial impacts of a hothouse world. Producing biased analyses that underestimate future costs is no longer an option. Adapt economic models or they’ll undermine both climate change mitigation and adaptation.”

Finance Watch recommends that financial institutions’ stranded fossil fuel assets exposures must be quantified, as well as extending the current 2030 time horizon used by EU financial institutions.

“While the frequency of extreme weather events is increasing, the risk of fossil fuel assets becoming stranded and economic collapse will not materialise by 2030,” the report explains.

This page was last updated October 31, 2023

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