1 Introduction and principal issues

Climate risk is a serious issue that must be addressed by the authorities and by the private sector. The Climate Risk Commission's report – Official Norwegian Reports (NOU) 2018:17 / Climate risk and the Norwegian economy – presents a thorough review of climate-related issues and their significance for the Norwegian economy, including financial stability.

Climate risk involves a wide range of factors that to a great extent lie outside the central bank's sphere of authority or direct influence. In this consultation response, Norges Bank wishes to focus on topics that are relevant to Norges Bank's mandate for central banking operations and for its management of the Government Pension Fund Global (GPFG).

Norges Bank supports the Commission's approach to discussing climate risk from an economic and risk analysis perspective. The Bank agrees that measures to promote robustness are an important way of addressing climate risk. The Bank also supports international recommendations on transparency and reporting principles. The Bank endorses the view that Norwegian businesses depend on well-functioning international trade and on knowledge disseminated through international institutions. At the same time, the Commission points out that climate change may destabilise international politics. All of these factors point towards the importance of international cooperation on climate risk.

First and foremost, Norges Bank would emphasise the paramount role of market pricing in the efficient allocation of resources. Pricing the economic cost of greenhouse gas emissions is fundamentally important. Pricing emissions is essential in the effort to reduce greenhouse gas emissions. The key tools in addressing climate risk are therefore primarily those components of fiscal policy that can correct a known market failure through tax-adjusted market prices.

Norges Bank's mission is to promote economic stability by conducting monetary policy and monitoring the financial system. In line with the Act on the Government Pension Fund, the Bank also has the responsibility for managing the GPFG in accordance with the mandate issued by the Ministry of Finance. A feature common to both of these mandated responsibilities is the identification and management of risk. Environmental and climate-related issues constitute a set of risks facing Norges Bank, directly or indirectly, in the exercise of its tasks.

This means that the Bank is highly alert to climate-related work undertaken in Norway and internationally. Norges Bank encounters climate-related and environmental issues in its economic analyses and its operational activities. An important role for the central bank is to contribute to a knowledge-based public debate.

Sections 2 and 3 of this consultation response describe the relevance of climate risk for the analyses and operations in the two main functions within Norges Bank's mandate. Section 4 presents an international perspective relevant to Norges Bank's work on climate risk.

2 Transmission of climate risk to the economy and financial stability

The Climate Risk Commission points out that the relevant authorities should build climate-risk competence to ensure that potential climate-related risk factors for financial stability are identified and managed. Norges Bank agrees.

Climate risk can have an impact on macroeconomic developments and financial stability. Both physical risk and transition risk may affect the Norwegian economy. An early and gradual transition to a low-carbon economy will involve costs in the short term, but the alternative could lead to an abrupt adjustment later. Sudden effects resulting from climate change can involve large direct costs, for example after natural catastrophes, but can also lead to unexpected and substantially tighter climate policy measures and regulations. The consequences can be greater financial systemic risk and a more substantial impact on the economy. The range of outcomes is wide and difficult to predict.

Norges Bank has conducted analyses of the relationship between technological developments, climate policy measures and banks' credit risk. International cooperation is creating a basis for further analysis ahead. For Norway, a large oil sector may pose a distinctive risk associated with weaker future oil demand. The oil service industry may be particularly vulnerable. An abrupt decline in oil-related activity will have considerable repercussions for the Norwegian economy and could be a potential source of substantial bank losses.

Banks' risk weights for loans are based on historical loan losses and are less suited to capturing structural changes such as climate risk. Developing scenario analyses and stress tests specific to this field could contribute to strengthening our knowledge of climate-related risk.

Norges Bank focuses on ensuring that the economy in general and the financial system in particular are sufficiently resilient to severe downturns and shocks. Norges Bank conducts stress testing to assess banks' ability to withstand severe economic shocks. Such stress tests could also include climate risk scenarios.

The Commission notes that monetary policy authorities that clearly express how they intend to manage potential future supply-side shocks could provide a better basis for climate risk management in the private sector.

Norges Bank has operated an inflation-targeting monetary policy regime since 2001. The inflation-targeting framework has proved to be robust in the face of substantial shocks, such as the 2008 international financial crisis.

Supply-side economic shocks can pose a dilemma for monetary policy. For example, food or energy price increases can push up overall inflation, and monetary policy cannot counteract the rise without at the same time reducing output and employment. Climate change can increase the frequency of extreme weather events such as drought, floods, hurricanes and severe temperature fluctuations, affecting food production and giving rise to higher food and energy price volatility.

Under flexible inflation-targeting, transient supply-side shocks will not normally lead to changes in the policy interest rate. Persistent negative supply-side shocks, resulting in second-round effects on overall price and wage inflation, are normally counteracted by increasing the policy rate. Nonetheless, there is a risk that climate-related shocks could trigger such a large fall in demand that uncertainty about future economic developments induces households to save more and causes a sharp fall in house prices and other asset prices. The overall effect of the shock may then mean that the policy rate should be lowered, not raised.

Monetary policy cannot shield the economy from the costs of climate-related shocks. Monetary policy can curb the impact of shocks and provide a reasonable balance between avoiding excessive inflation and avoiding an excessive fall in output and employment.

The risk associated with climate change suggests that Norges Bank should strengthen its work on analysing the effects of climate change on the Norwegian economy.

3 Significance of climate risk for financial investments

The Commission highlights the central role played by the financial sector in a market economy and the key question of what it will take for this function to be performed well in the transition to a low-emission society. The transition to a low-emission economy requires large-scale investments, and a substantial share of these investments will be channelled through financial markets. The Commission asserts that if financial market participants have a good understanding of the risk associated with climate change, investors and the financial industry could contribute to the transition through good corporate governance, credit provision and the development of new products and instruments. The Commission emphasises that a lack of information inhibits financial markets and increases climate risk and that a mispricing of climate risk and misallocation of capital can also increase the risk of financial instability in the long term. The Commission recommends methods such as good reporting and corporate governance.

Norges Bank would emphasise that, in general, the transition to a greener and more sustainable economy will make substantial demands on businesses and investors, but will also provide opportunities. Technological advances and innovations are a necessary part of the process towards more sustainable economies. At the same time, climate change exposes businesses to a new type of risk. As the ways in which firms prepare for possible future restructuring will affect expected return and risk, many investors impose requirements on firms' reporting on climate-related issues. Financial investors must manage climate risk on a par with other types of risk. The financial sector must adapt to climate risk. The responsibility for fundamental policy measures lies with the authorities.

The Commission refers to the need for relevant information about climate risk in financial markets and highlights the recommendations of the Task Force for Climate-related Financial Disclosures (TCFD), an international initiative supported by Norges Bank. The Bank's work is based on expectations conveyed to companies and has over time given particular weight to improving corporate reporting.

The Commission also underlines that climate risk and the transition to a low-emission economy necessitate good corporate governance. Norges Bank agrees on the importance of good corporate governance. The main focus of the Bank's active ownership activities in relation to the GPFG's investee companies is profitability. Given this overriding perspective, active ownership is an instrument in the Bank's efforts to ensure that the companies in the investment portfolio are well prepared for the transition to a low-carbon society.

The Commission recommends that a good understanding of climate risk should be integrated to a greater extent in decision-making processes in both the private and the public sector, with increased use of scenario analyses as a key element. Norges Bank, in its management of the GPFG, expects investee companies to assess how exposed their long-term business strategy and profitability are under future climate risk scenarios. Such analyses may be useful to explore the consequences of different actions, passive or active, as they provide an illustration of different outcomes, without presenting predictions of the future.

4 International cooperation on climate risk issues

In the years following the second world war, the establishment of multilateral and regional institutions laid the basis for closer cooperation on economic policy in a range of areas, creating room for the exchange of ideas and knowledge. An important part of climate risk is associated with real economic costs or the implementation of abrupt and substantial changes in policy. The Commission states that owing to the considerable uncertainty related to global developments, there is a very wide range of possible outcomes for the Norwegian economy. This shows that the role played by international cooperation in a multilateral setting is also a key element in addressing climate risk.

Norges Bank became a member of a new international network called "Central Banks and Supervisors Network for Greening the Financial System" (NGFS) in December 2018. The primary objective of this network is to create an arena for central banks and financial supervisors to exchange experiences and share best practices in developing environment and climate risk management in the financial sector. The members of the NGFS are focusing efforts on systematic learning and competence-building. At the same time, the members recognise that there is much we still do not know about climate risk, including market dynamics and risk patterns for "green" compared with "non-green" investments. The new network is also a meeting place where the objective is to arrive at a good understanding of a reasonable framework for the role and activities of central banks in this field.

Yours sincerely,

Øystein Olsen

Birger Vikøren