Portugal Central Bank Statement

Author: IFLR Correspondent | Published: 24 Sep 2019
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Environmental concerns have rocketed to the top of both domestic and global policy agendas over the past three years. Institutional arrangements and policy initiatives have proliferated, raising the awareness of consumers, savers, financial intermediaries and investors. A sense of emergency to safeguard our collective future prosperity is taking centre stage.

Conceptually, environmental sustainability boils down to a classic economic problem of externalities and time inconsistency, whereby those contributing to harm the environment are not bearing (or internalising) the corresponding cost. This is aggravated by the so-called 'tragedy of the horizon': while the environmental impact of current investments, production and consumer decisions is felt over the long term, the costs to address such an impact are incurred immediately. Consequently, the levels of environmental degradation are far above what would be socially desirable, imposing a heavy burden on certain sectors of the economy and society, and most notably on the future generations.

From the financial sector's perspective, the critical question is how to ensure that risk pricing underlying lending decisions reflects a full and fair evaluation of sustainability. Indeed, the sustainability analysis of a firm or investment project requires that all foreseeable risks are taken into account: not only market risks from competition or technological change, but also regulatory risks and risks to future availability or cost of inputs.

Environmental risks are at the very heart of this equation, either because they will lead to regulatory or policy changes, or because they will generate demand or supply shifts, as sustainability concerns gain prominence in consumer behaviour and certain resources become scarce. Any profitability analysis that does not consider environmental risk and the horizon in which it is likely to materialise, will necessarily overestimate the viability of the investments concerned.

Implications for financial stability are direct and profound, which means that there is a role to be played by financial regulators and supervisors in generating incentives for the financial sector to take environmental risk into account. This role includes: (i) reviewing regulations to detect gaps that could potentially 'subsidize' some projects or borrowers in detriment of sustainable finance; (ii) establishing a dialogue with the industry and raising sustainability awareness through communication initiatives; (iii) communicating supervisory expectations on how financial institutions should enhance their approach to managing climate-related risks; (iv) developing analytical tools and supervisory instruments (e.g., stress tests); (v) and last but not least, leading by example by integrating sustainability principles into their own management, and most notably into their asset management practices.

Such action on the part of financial regulators and supervisors is certainly necessary and urgent, but far from sufficient. Dealing with threats to environmental sustainability requires a broad based and holistic public policy approach, mainly directed at addressing the problem at the source and pricing all climate-related risks. Authorities responsible for tax, competition and innovation policies, as well as for financial disclosure requirements, should be at the forefront of the fight against environmental degradation. Furthermore, the global dimension of the problem calls for international coordination and global governance, in order to safeguard a level playing field. In the end, it is all about how to better manage globalisation and maximise its benefits.