1. The Sustainability–Financial Risk Nexus

See for example UNEP (2016) or Berrou et al. (2019a).

The Paris Agreement resulted from the United Nations Framework Convention on Climate Change (UNFCCC), an international environmental treaty that aims to limit global greenhouse gas (GHG) emissions and that is still in force today. Starting from 1995, signatories of the UNFCCC met on a yearly basis, through the Conferences of the Parties (COP). In 1997, as result of the conference held in Kyoto (COP 3), the Kyoto Protocol extended on the UNFCCC and led to the establishment of the first global legally binding obligation addressing climate change. The Paris Agreement was signed during the COP 21.

Among the other noteworthy initiatives on the defence of the environment, in May 2015 the Pope Francis addressed the subject of environmental degradation and climate change in a historical encyclical letter “Laudato sí” on “Care for Your Common Home”.

The UNFCCC had some encouraging results already before COP 21. In 1997, as result of the conference held in Kyoto (COP 3), the Kyoto Protocol led to the establishment of the first global legally binding obligation addressing climate change.

The objectives that were announced during the agreements will be revised in 2020, and once every five years after that initial revision. An overall assessment will be performed in 2023, and, once more, will occur every five years.

In addition, in June 2017, United States President Donald Trump announced his intention to withdraw his country from the Paris Agreement. Under the agreement itself, the earliest effective date of withdrawal for the United States is November 2020.

In particular, net-zero carbon emissions at global level need to be achieved not beyond the half of this century and neutrality for all other GHG not much later.

As an example, investments of around EUR520–575 billion annually have been estimated to be necessary in the EU only in order to achieve a net-zero GHG economy in the 2050 horizon (Source EC 2018b).

For a wider dissertation on green finance and the challenges it faces, see Migliorelli and Dessertine (2019a).

For a discussion on the definition of green finance, see Berrou et al. (2019a).

Climate change mitigation usually refers to efforts to reduce or prevent emission of GHG. Climate change adaptation normally concerns the adjustments in ecological, social or economic systems in response to actual or expected climatic modifications and their effects or impacts.

See Berrou et al. (2019b).

The growth of sustainable finance in the last decade should be also related to a strong commitment of the major stock exchanges worldwide. Financial centres such as London, Paris, Luxembourg, Copenhagen, Amsterdam in Europe, Shanghai and Beijing in China, San Francisco and Los Angeles in the United States, Vancouver and Montreal in Canada have taken the lead and are progressively improving the quality and depth of their sustainable finance offer. To this extent, dedicated listings for sustainable finance and green finance securities have emerged.

Nevertheless, some challenges still exist and mainstreaming sustainable finance can be considered a long-term objective. In particular, clearly identifying the sectors or activities eligible for sustainable finance, better assessing the (still unclear) financial benefits for issuers of sustainable securities, coping with the lack of incentives for market actors of entirely factoring in the sustainability-related risks in their investment decisions are some of these challenges. In addition, to effectively mainstream sustainable finance, some conditions need to be fulfilled. Namely, environmental risks are properly included in the investors’ decision-making processes, market demand is effectively channelled towards sustainable investments, additionality is adequately encouraged by policymakers, the banking sector is fully engaged in the transition. For a wider discussion on these subjects, with a focus on green finance, see also Migliorelli and Dessertine (2019b).

Financial stability can be defined as a condition in which the financial system—which comprises financial intermediaries, markets and market infrastructures—is capable of withstanding shocks and the unravelling of financial imbalances. This mitigates the likelihood of disruptions in the financial intermediation process that are systemic, that is, severe enough to trigger a material contraction of real economic activity (ECB website, consultable here: https://​www.​ecb.​europa.​eu/​pub/​financial-stability/​fsr/​html/​ecb.​fsr201911~facad0​251f.​en.​html#toc1).

Based on EC (2019b), weather-related disasters caused a record EUR 283 billion in economic damages in 2017 and could affect up to two-thirds of the European population by 2100 compared with 5% today.

In this respect, a noteworthy initiative is the establishment of the Network for Greening the Financial System (NGFS), launched at the One Planet Summit in Paris in December 2017 under the initiative of the Banque de France. Composed by more than 30 central banks and supervisory bodies (including Banco de España, Bank of England, Bank of Finland, Banque Centrale du Luxembourg, Deutsche Bundesbank, European Banking Authority, European Central Bank, Japan FSA, National Bank of Belgium, Oesterreichische National Bank, the People’s Bank of China, the Reserve Bank of Australia, Reserve Bank of New Zealand), it aims on a voluntary basis to exchange experiences and best practices, to contribute to the development of environment and climate risk management in the financial sector, and to mobilise mainstream finance to support the transition towards a sustainable economy. In 2019, the NGFS issued the first comprehensive report on climate change as source of financial risk (NGFS 2019).

Even if not linked to financial risks, sustainability-related risks have nevertheless recently started to be considered as crucial factors in the development of modern society. Extreme weather events, failure of managing climate change mitigation and adaptation, natural disasters, man-made environmental disasters, large-scale involuntary migration, biodiversity loss and ecosystem collapse, water crises, occupy seven positions in a top ten of risks by likelihood by the World Economic Forum (WEF 2019).

The United Nations Environmental Programme Finance Initiative (UNEP FI) provides a methodology for assessing physical risk (UNEP FI 2018). It recommends considering both changes in average weather conditions and the more frequent occurrence of extreme events. To implement these exercises, it would be necessary to improve the available data, in particular on the geographical location of borrowers, to improve macroeconomic models that integrate the impact of climate change and to anticipate difficulties that the insurance sector could experience.

Some first structured attempts to specifically analyse the incidence of these risks has been indeed made in Europe by the British Prudential Regulation Authority (PRA) in 2018 and by the French Autorité de contrôle prudentiel et de resolution (ACPR) in 2019. The PRA surveyed a number of UK banks on the possible incidence of climate change-related risks (PRA 2018). Relevant conclusions included: (i) for banks, the financial risks from climate change have tended to be beyond their planning horizons (for 90% of the UK banking sector these horizons averaged four years—before risks would be expected to be fully realised and prior to stringent climate policies taking effect); (ii) the majority of banks are beginning to treat the risks from climate change like other financial risks rather than viewing them simply as a corporate social responsibility issue; such banks start to oversight the financial risks from climate change and assign the overall responsibilities for setting the strategy, targets and risk appetite relating to these risks (including at board level); (iii) banks have begun considering the most immediate physical risks to their business models and have started to assess exposures to transition risks where government policy is already pulling forward the adjustment (this latter includes exposures to carbon-intensive sectors, consumer loans secured on diesel vehicles, and buy-to-let lending given new energy efficiency requirements). Similarly, the ACPR surveyed the main French banking groups (ACPR 2019). The main conclusions stemming from the survey were: (i) banking groups appear to have relatively little exposure to physical risk on the basis of currently available scenarios and expected impacts are mainly concentrated in low-vulnerability geographical areas (nevertheless, the industry seems to be aware that the full risk is not necessarily and fully transferable to the insurance sector); (ii) achieved progress in the area of transition risks was the most significant as banking institutions consider themselves being more directly exposed to this risk (in the mid-term), even though this trend is unevenly distributed across banking groups (institutions underlined that the horizon for transition risk is much closer to the one underlying their strategic thinking); (iii) most of respondents consider not to be exposed to liability risk in a material manner, even though the number of litigations is increasing at the international level and institutions are encouraged to seize this topic.

For example, it has been observed that warming in the Indian Ocean and an increasingly concentrate precipitations (as in the case of hurricanes) could reduce main-season precipitation across vast parts of the Americas, Africa and Asia (Brown and Funk 2008).

For a similar exercise, limited to climate change, see TCFD (2017, pp. 10 and 11).

Similar conclusions seem to emerge from the recent studies of the British Prudential Regulation Authority, PRA, and by the French Autorité de contrôle prudentiel et de resolution, ACPR (see PRA 2018 and ACPR 2019).

For a wider discussion on this issue, see Chapter 4.