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Nearly a decade on from the 2015 Paris Climate Agreement, global carbon emissions are still rising. The European Union is one bright spot where emissions have decreased. But even in the EU, banks have not fully internalised the costs of transitioning to net-zero by 2050 and they continue to finance the expansion of the fossil-fuel industry. At the systemic level, this is trading a pretence of financial stability now for a more disorderly transition, with greater financial instability, later.

This is despite the increasing use by central banks of microprudential supervisory tools to address climate-related financial risks. These tools include reviews of banks’ risk-management processes and issuing of warnings when supervisors see shortcomings in banks’ risk models. This approach is helpful, but has so far failed to address the build-up of climate transition-related imbalances in the financial system. It echoes the run-up to the 2007-2008 global financial crisis, when supervisors were busy reviewing the implementation of the latest Basel risk models by individual banks, while failing to see increased imbalances in the financial system overall caused by rising housing prices.

Central banks should take a macro approach towards managing systemwide-risks stemming from the climate transition. The policy aim for central banks, in their macroprudential supervision capacity, should be to minimise financial instability during that transition. All things being equal, the steadiest path towards net-zero offers the greatest amount of financial stability.

This policy brief recommends doing more to guide banks that have been reluctant to hive off profitable loans to high-emitting companies through the climate transition. In particular, introducing a requirement for the financial sector to decrease the emissions it finances by four percentage points annually from 2025 to 2050 would deliver net-zero with the least amount of financial instability.

Read the new Policy brief by Dirk Schoenmaker and Hesse McKechnie: What can central banks do to take the Paris Agreement seriously? 

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