Developing a Precautionary Approach to Financial Policy

While central banks and financial supervisors have primarily approached climate change and biodiversity loss from a financial risk perspective, the non-linear dynamics and long time horizons involved in these risks make quantitative analysis challenging, if not impossible.

This peer-reviewed paper by researchers from University College London and the New Economics Foundation proposes an alternative approach. The authors suggest employing the precautionary principle to manage and mitigate these systemic – and potentially existential – threats, offering a policy framework to move towards a precautionary mindset.

Central banks and supervisors currently rely on climate risk measurement and disclosure, using tools such as scenario analysis and climate stress tests. However, the paper argues that these scenarios come with no foreseeable capacity for the precise quantification needed to calibrate concrete financial policy interventions against climate change. This leaves financial institutions with subjective perceptions of upcoming economic changes as a result of environmental factors, disconnected from the imperatives learned from science.

Faced with potentially catastrophic outcomes subject to radical uncertainty, the paper advocates the clear and proactive steering of financial markets away from ecological tipping points,towards building economy-wide resilience instead.

Specific policies proposed include negative screening of unsustainable assets, active use of capital adequacy rules and the use of credit guidance policies. To shift the financial sector towards a precautionary mindset, the authors also call for recognition of the limitations of ‘market neutrality’, greening monetary policy portfolios and macroprudential policy, and more interventionist financial policies concerning the dual climate and biodiversity crises.

The paper concludes with the observation that there has been less progress in high-income economies compared with emerging and developing countries that have a strong tradition of policy coordination between financial authorities, economic development, and industrial policy.

This is the second policy briefing in Inspire’s Sustainable Central Banking Toolbox series supporting central bankers and financial supervisors in calibrating monetary, prudential and other instruments to address climate change and other environmental challenges.