Green Deal and the supervisory perspective
In December, the European Commission published the Green Deal, an action programme for sustainable growth. It is a package consisting of over 50 actions, geared to steering Europe onto a development path toward carbon-neutrality by 2050. The programme as a whole is ambitious but necessary in light of the risks threatening our living environment.
The most crucial components of the Green Deal are related to the emissions trading scheme and its broadening, a considerable reduction in transport sector emissions, food production, various forms of economic support and also the financial sector. The role of the latter is naturally emphasised since achievement of the targets for 2030 alone requires further annual investment of EUR 260 billion, which requires a considerable activation of private investors.
Large and rapid changes increase risks in the financial sector
The proposed actions would change the structures of the economy in a significant manner. Economic transition periods have typically accelerated economic growth, but they also always involve uncertainties and threats. As an example, let us take the proposal concerning carbon border taxes, which might also lead to an unwanted outcome. Likewise, rapid transition from fossil energy sources to renewables affects EU member states differently, and therefore the economic impacts at country level may be contrary to what is expected, depending on the situation of each country at the outset. If all changes were to take place at the same time, the risks to the stability of the economy and the financial system would also increase steeply.
The demand for green investments is already about to exceed supply even in the absence of the Green Deal, and therefore there are concerns of an emergence of a green bubble. For the time being, the taxonomy for environmentally sustainable economic activities finalised towards the end of Finland's EU presidency only covers under five per cent of all investments, and therefore as the demand for green investments increases, so does the risk of overheating of the market. This is something both central banks and supervisors must keep a close eye on.
Prudential requirements providing security to the financial system
The FIN-FSA pays particular attention in the Green Deal to a proposal to grant concessions to the prudential requirements for the financial sector based on the greenness of the risk exposures – for example, the capital requirement for investments in energy-efficient properties could be reduced. The adjustment of prudential requirements is not being proposed for the first time, as the Commission action plan on sustainable finance published already two years ago suggested studying the matter, but the Green Deal takes a somewhat more stringent stance on the matter.
The capital requirements imposed on the exposures of banks and insurance institutions are based on loss probabilities calculated on the basis of historical time series. Previously, this approach was effective, or at least the best available. The risks associated with the sustainability of the environment pose a challenge to this way of measurement, however, since risks related to climate change, for example, are not yet apparent in historical data. This was highlighted when the European Insurance and Occupational Pensions Authority published its report on the matter in summer 2018. There are no easy solutions to the problem, since alternative forward-looking forecast models involve such significant uncertainties that their application as the basis for prudential requirements for the financial sector would be rather questionable.
The prudential requirements framework for the financial sector is a risk management tool laying the foundation for the stability and credibility of the system. If the decision is made to give up the pure risk-based foundation of the prudential requirements framework, from the perspective of the supervisor it would be safest to only increase the capital requirements for environmentally detrimental activities, even if this alternative is not mentioned in the Green Deal. Highlighting the threats and financial sector risks seems to be left as a task for supervisors and central banks.
Acknowledgement of risks supports climate actions
Although this discussion has presented threats related to the Green Deal, sustainability risks also pose a significant risk to the financial sector, and preparation for them is an important part of the management of systemic risks. However, the supervisor must also highlight and prepare for potential risks involved in a project such as the Green Deal.