Climate risks push prudential transition plans to the top of central bank agendas

Central banks need to look beyond their traditional policy toolkit to safeguard financial stability against climate-related financial risks, leading central bank officials and former policymakers argue.

At the centre of the debate are prudential transition plans, which require financial institutions to assess, manage and disclose how they will address the risks arising from the transition to a low-carbon economy. Supporters argue they can help banks prepare for the economic shifts ahead while giving supervisors greater visibility over potential vulnerabilities in the financial system.

“Climate transition risks should be seen as systemic risks and need to be addressed now,” said Sarah Amorim Torres, deputy advisor in the prudential and foreign exchange relations department at Banco Central do Brasil.

Speaking at a World Resources Institute (WRI) webinar following the Santa Marta conference on the transition away from fossil fuels, Amorim Torres said that while guaranteeing price and financial stability remains the core remit of all central banks, approaches vary between institutions, particularly when it comes to sustainability factors. 

For instance, since 11 January, the European Central Bank (ECB) has required all banks under its supervision to publish prudential plans explaining how they will manage the financial risks arising from the transitioning to a low-carbon economy. The ECB is the first central bank in the world to impose such a requirement through the implementation of the recently amended Capital Requirements Directive VI, a core EU banking regulation.

The move seems to be at odds with the EU Commission’s recent simplification drive – the so-called “omnibus” revisions – which relax corporate sustainability rules, including by reducing the number of companies having to publish corporate transition plans.

The omnibus package has raised concerns that banks could receive less sustainability data from some corporate clients that are no longer required to report it. Industry groups have claimed this could make it harder for banks to assess transition risks and prepare their own prudential transition plans.

Amorim Torres argued that transition pathways need to be clearly defined across the economy as to enable credible prudential transition plans.

Roadmaps away from fossil fuels

One of the workstreams to emerge from the Santa Marta conference last April was the development of national and regional roadmaps away from fossil fuels.

The final outcome report, unveiled at London Climate Week in June, was described as the strongest show of support to date for a Fossil Fuel Treaty, with campaigners describing it as “historic”.

The report also mentioned the role central banks and financial institutions play in managing transition risks, with fossil fuel dependency triggering wider macroeconomic and financial vulnerabilities.

The discussions demonstrated a growing awareness among policymakers that fossil fuel dependence is not only an environmental challenge, but also an economic one.

Speaking at the webinar, Kjell Kuhne, director of Leave It In the Ground Initiative, said the meeting proved central banks are not a “subtopic” of the transition but key to maintaining financial stability throughout it.

Frank van der Vleuten, coordinating policy officer of climate finance at the Ministry of Foreign Affairs in the Netherlands, who co-hosted the conference with Colombia, said central banks’ mandate needs to be clarified further. 

“Central banks have a different role from governments. Policymakers work with a short-term horizon … how do we bridge that gap in perspective to be more effective in the longer term?”

The multilateral conference took place while many energy-importing countries were suffering price shocks due to the ongoing US-Israel war on Iran.

“We did not expect this [the Santa Marta conference] to happen in the midst of the Iran crisis,” van der Vleuten said.

Jwala Rambarran, former governor of the Central Bank of Trinidad and Tobago, urged central banks to do more to assist countries in moving away from the “debt fossil fuel trap” – a term coined to describe how countries in the global south rely on fossil fuel revenues to repay debt accumulated through expensive borrowing.

“We need reforms to global financial architecture to access finance based on vulnerabilities, not income levels,” he said.

Rather than simply providing liquidity, he argued that central banks need to play a “catalytic role” in coordinating domestic policy with international institutions to mobilise capital.

“Incremental adjustments from central banks are not enough to transition. They need to reshape the debt fossil fuel trap. Central banks can’t produce the transition on their own…but they can do extensive research on this. Anything that is macro-critical is a concern for central banks.”

The Santa Marta conference on transitioning away from fossil fuels convened more than 50 governments and a dozen stakeholder groups, including the WRI. However, the world’s three largest emitters – China, the US and India – and major fossil fuel exporters, such as Russia and Saudi Arabia, were absent from the discussions. Unlike the COP meetings, where a final text must be agreed by consensus, Santa Marta focused on cooperation between governments and stakeholders, establishing work streams on issues including finance, transition roadmaps, including one aimed at dialogue between producers, importers and vulnerable states.

A follow-up conference is planned next year in the Pacific island nation of Tuvalu, which will be co-hosted by Ireland.

Written by