Finance in a Hot House World

November 2, 2023Published by Finance Watch

Global greenhouse gas emissions are on track to cause temperature increases of +3°C or more, a situation that climate experts call the “hothouse scenario”. The latest report by Finance Watch “sounds the alarm” on underestimating the economic losses of climate events and makes recommendations to improve macroprudential policy.

The report acknowledges that while policymakers agree that climate risk is a systemic threat to banks, but that existing macroprudential tools are poorly suited to managing that risk. As a solution, the authors recommend a loan-to-value (LTV) macroprudential tool.

The tool would see a capital surcharge triggered once a certain threshold of climate-related risk is reached. The LTV 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 report recommends taking a 2°C global warming reference and setting the LTV limit at 100%. Finance Watch estimates that the LTV ratio is currently extremely high at 437% and as a practical risk management solution suggests a 12% capital requirement for the part of existing fossil fuel assets that will become stranded.

The proposed LTV tool would combine borrower-based and capital-based features, activating the capital feature in direct proportion to the additional systemic risk caused by the loan. It would follow transparent rules and metrics and focus on the highest-emitting activities at risk of stranding.

In addition, the report recommends making the EU’s one-off scenario analysis “useful”. The scenario analysis sought to anticipate shocks to the financial system that could imperil financial institutions, the financial system, or the EU’s ability to achieve its climate goals, as well as react quickly to any such adverse shocks.

The report claims that done well, this analysis can provide actors in the financial sector with credible information with which to make decisions in a hothouse world. However, the current time horizon of 2030 set for this exercise undermines its objective. While the frequency of extreme weather events is increasing, the risk of fossil fuel assets becoming stranded and a subsequent economic collapse will not materialise by 2030.

The report also recommends quantifying stranded fossil fuel asset exposures and extending the current 2030 time horizon in line with the increasing likelihood that economic activity will begin to collapse in 2050, before accelerating to catastrophic levels between 2060 and 2080.

This page was last updated November 2, 2023

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