Exploring a macroprudential complement to transition planning
A macroprudential perspective to accompany the more usual microprudential focus can support the successful development of transition plans that reduce greenhouse gas emissions, while also offering holistic management of financial risks along the transition. Paul Hiebert, Agnieszka Smoleńska and Fabio Tamburrini explain the benefits and implementation challenges.
Transition plans hold considerable promise as a means for prudential supervisors to assess, address and bring distant financial climate and environmental risks into the present. For organisations, transition planning allows them to structure, articulate and implement their overall strategy to adjust their business to the low-carbon transition. The output of such processes, namely outward-facing transition plans, provides scope for a time-bound action plan – setting out targets and actions supporting companies’ strategies to reduce greenhouse gas emissions, and establishing the necessary risk-management practices to manage the related financial risks.
Such plans can contribute to ameliorating informational and allocative inefficiencies that obfuscate financial market signals and economic adjustment. Most notably, transparency associated with widespread availability of such plans can support the financial market’s ability to price climate risk as well as individual firms’ ability to manage risks, including by enabling them to assess the transition risk to which their counterparties and clients are exposed.
Numerous strands of work have sought to establish principles and frameworks for transition plans of firms – both financial and non-financial.[1] By providing a bottom-up description of the future adjustment trajectory of individual firms to the green transition, transition plans have also been identified as potentially powerful tools to bridge existing gaps in the identification and management of climate-related financial risks, which are intrinsically challenging due to their forward-looking nature.
A top-down complement to bottom-up transition planning
Prudential work on transition plans to date has focused on the microprudential dimension – that is, at the level of individual institutions, particularly banks. But a macroprudential, or systemic, dimension can act as a powerful complement, to identify and address potential instability along the transition towards a low-carbon economy at the level of the financial system and its interactions with the real economy. Thus, adding a macroprudential dimension would ensure safety and soundness not only of individual institutions, but also of system-wide resilience of the financial system against risks from climate change.
A focus on individual institutions may not capture the scope for complex economic and financial interactions in at least two ways – as outlined in Figure 1 below. First, there may be a fallacy of composition – whereby risk to the system is not a sum of its parts as the transition unfolds, as the financial sector adjusts to meet official net zero alignment initiatives at the national and regional level (see, for instance, the results of the EU Fit for 55 stress test exercise). Second, there may be real economy–financial system misalignments – whereby mismatches between the former and the latter could create scope for shocks that would affect financial stability.
Figure 1. Micro- and macroprudential use cases of transition plans
Dynamic recalibrations
The success of the green transition from a financial stability perspective hinges on the economy’s ability to perform the substantive transformation of its productive structures, while minimising financial disturbances and instability. This transformation will inevitably require active recalibration of living and dynamic transition plans as vital information about the evolving potential for uncertain risks and impacts comes to light.
The availability of a set of forward-looking projections from individual firms can play an important coordinating role for market actors, but also constitute an essential source of information for policymakers. A macroprudential perspective to transition planning can give insights on how this transition process collectively unfolds. To this end, information derived from aggregating bottom-up transition plans can be checked against a system-level top-down cross-check on modelling the evolving macro financial environment.
As well as being useful for general assessments, such cross-checking could also signal specific pressure points – informing public authorities on the sensitivity of sectors and economies to future macroeconomic and financial conditions, and the potential interaction of climate-related and more traditional forms of financial risk drivers. The progress and future pace of the transition derived from transition plans may help both financial institutions and authorities identify where lending plans of financial institutions are not aligned with the capital expenditure planning in the real economy – notably if the financial sector lenders’ decarbonisation commitments are inconsistent with the pace of transition of borrowing firms.
Distinguishing between risk build-up and risk materialisation
Trade-offs between different types of risk will surely materialise during the transition. On the one hand, a risk build-up phase may accompany deviations from an ‘orderly’ transition – entailing aggravated physical risk if continued investment in emissions-intensive activities delays the transition, and damage to the economy in case of an overzealous ‘on paper’ decarbonisation, e.g. through short-sighted divestment. On the other hand, a corrective/risk materialisation phase may result in financial contagion in the case of risk crystallisation and propagation. This dichotomy between the time and cross sectional dimensions of systemic risk, as well as real-economic feedbacks spanning both perspectives, can help frame different angles inherent to a macroprudential approach to transition planning (Figure 2).
Figure 2. Risk build-up, risk materialisation… and the macroprudential space in between
Mind the speed limit(s)
Related to risk build-up, a macroprudential approach to transition planning and plans can contribute to ensuring an orderly pace of system transition – that is, one that is neither too slow nor too fast, informing the optimal policies to ensure an orderly transition of the real economy.
Transition plans, taken together, would provide information on the pace of transition along the continuum between insufficient adjustment and unduly stringent adjustment for the real economy and financial system. At one end, the ambition in transition risk adjustment needs to be sustained: climate scenario analysis to date has emphasised the benefits of an orderly transition and early adjustment over delayed or absent adjustment (that is, a minimum speed limit). At the other end, the macroprudential regulator might need to have a “foot on the brake” if microprudential regulators “hold too strongly an accelerator” and unwittingly impose a welfare-damaging credit contraction(that is, a maximum speed limit). Such a fine balancing act, and analytically robust approach, could support a consistent adjustment of the financial sector and the real economy, particularly in the context of an accelerated transition.
Handling the varying speeds that hide beneath the aggregates, and managing bottlenecks, is necessary to address the unintended consequences of climate change risk management, e.g. in case of uneven approaches among transition plans across the system. For instance, mismatches between plans and targets within the financial sector and the real economy can provide early warning of potential build-up of disorderly dynamics: such as if financial sectors’ decarbonisation commitments are inconsistent with more gradual transition plans held by the real economy.
Tracking materialising risks
With our understanding of the plausible mechanisms of risk materialisation and diffusion across the system advancing, information derived from transition plans can shed light on the interplay between institutional sectors (governments, real economy and the financial sector) and an assessment of spillovers (across countries, and within and between sectors). The interconnections between different parts of the system – banking, insurance and other non-bank forms of intermediation – may be particularly vulnerable as the risks begin to materialise.
Relating to risk materialisation, addressing the challenge of climate change impacts at the level of the financial system is complex, with many moving parts. Beyond tracking the latter, effective implementation would require articulating and developing a process for reconciling the different objectives related to the strategic transformation of the real economy and risk containment along the process of adjustment.
Straightforward in theory, complicated in practice?
Conceptually, the case for a macroprudential perspective on transition plans seems quite clear. There are several implementation challenges, however.
First, dedicated conceptual and analytical tools to monitor and assess system-wide transition inconsistencies or pressure points remain in their infancy at best – both with a view to enacting preventative or corrective action, and carefully calibrating efforts. Further work is needed to develop robust methodological approaches to structural and dynamic assessments that overcome fallacies of composition and support the reconciliation and interoperability of top-down and bottom-up risk assessment of transition plans.
Second, the basis for micro–macro coordination would need to be better articulated – notably, including mechanisms to resolve prospective disputes. There is a space where micro- and macro- perspectives are mutually reinforcing, but the distinct concerns of these policy instruments should not be ignored. Further forms of exchange and coordination that do not compromise the differentiated perspectives should be developed, to inform the discussion around transition plans. For example, authorities may engage in sequential or competitive forms of coordination in a way that reinforces policy credibility, in particular where short-term trade-offs may lead authorities to different assessments.
Third, there are boundary issues – whereby prudential assessments may need a broad scope (and notably beyond banks as linkages with non-bank financial intermediation grow), to address the level playing-field question both within and beyond the financial sector. Macroprudential transition plans can identify the persistent gaps and serve as a platform to engage with specific parts of the financial and economic system that raise concerns from the perspective of financial stability in the transition.
Responding to these challenges will require a thoughtful and evidence-based discussion on questions of mandates and policy interactions. Further research and analytical work can help address these outstanding questions, and provide the needed foundation to inform policymakers in the ongoing regulatory and legislative processes at the global and jurisdictional levels.
[1] These include official sector initiatives, such as the International Sustainability Standards Board (ISSB) and the Network for Greening the Financial System (NGFS), private sector initiatives such as the Glasgow Financial Alliance for Net Zero (GFANZ), and collaborations such as the Task Force on Climate-Related Financial Disclosures (TCFD).