The Transition to a Sustainable Post-COVID Economy Requires an Urgent Shift in Central Bank Risk Management

Council on Economic Policies
5 min readJul 10, 2020

By: Pierre Monnin

The COVID-19 crisis is profoundly and durably transforming our economies. So will the transition to a low-carbon economy, which is necessary to contain the environmental crisis ahead of us. Shifting our economic system from its current state to a sustainable post-COVID version entails large and uncertain transition costs — and thus substantial financial risks.

Managing financial risks associated with economic transitions is crucial for central banks as it falls squarely into their financial stability mandate. It is also essential to protect their balance sheets from undue financial losses.

Central banks usually rely on the same risk metrics as financial markets to set prudential policy, as well as for managing financial risks on their balance sheets. Yet, as painfully highlighted by the financial crisis in 2008, financial markets do not always deliver sound and reliable assessments of risks. The growing recognition that they tend to underestimate the financial risks associated with the transition to a low-carbon economy is a further case in point.

Against this background, central banks must treat the risk metrics used by financial markets with caution, especially when defining prudential regulation and risk management policies for their portfolios. They should, in particular, add a precautionary margin to these metrics to reflect the transition risk that financial markets are not accounting for.

Better reflecting transition risks is an urgent step that central banks must take to protect their balance sheets from unwanted and excessive risk exposures as well as to safeguard financial stability. It is also key to assist financial markets in fostering a smooth and timely transition to more sustainable and resilient economies.

Pandemic and environmental crises are radically reshuffling financial asset values

In a pandemic, as in many other crises, demand and supply for goods and services are radically reshuffled. The COVID-19 crisis, for example, has highlighted the importance of remote work and decreases demand for office space, as well as for transport and services associated with business travels.

Similarly, activities consuming significant amounts of fossil fuel are likely to be outdated in an environmentally sustainable economy. Firms producing such goods and services will face lower demand from consumers and higher relative costs — through, e.g., carbon taxes or increased competition from low-carbon technologies. Consequently, their cash flow will fall. Yet, cash flows are the cornerstone of asset valuations on financial markets: equities, debt and derivatives prices are all connected to the levels of future cash flows and to their timing. Reassessing them to reflect a transition to a new state creates a fundamental reordering of asset market prices, and thus substantial financial risks.

Markets are best suited to deal with risks! Really?

All firms are bound to be affected, to some extent, by the transition to a new sustainable post-pandemic economy. Thus, all financial assets that they issue or back also bear transition risks. Financial markets can manage these risks well if, and only if, investors adequately assess the size of transition costs, their distribution and their timing. If investors fail in assessing one of these dimensions, transition risks will eventually crystallize, as investors realize that their expectations are on the wrong track and consequently revise them downwards.

In this context, a crucial question is: do financial markets adequately reflect transition risks? The prudent answer is no. Financial markets are notoriously prone to short-termism, and thus to missing long-term transition risks. Moreover, they generally use past data to assess risk — an approach that investors can hardly rely on to gauge future costs of pandemics and environmental crises. As a result, investors are in an environment of radical uncertainty when it comes to assessing transition risks; an environment for which traditional risk management tools have limitations.

Taking precautions

Against this background, there is an urgent need for policymakers and investors to approach transition risks with caution. Financial policymakers must work with the assumption that financial markets underestimate transition risks. Concretely, this implies adding a precautionary margin to the risk metrics used by financial markets, to reflect possible transition risks that are unaccounted for.

Financial supervisors should integrate this precautionary principle in prudential regulation. Loans to firms exposed to high transition risks are — by definition — riskier than others. This should be reflected in microprudential regulation with higher capital requirements for loans to such firms. At the macroprudential level, financial regulators should also add precautionary capital buffers when significant parts of the banking sector are engaged in loans to firms exposed to transition risks. These measures would strengthen the banking sector in case of a crisis, as well as incentivize banks to lend to firms who are building up resilience to pandemic and environmental crises.

What about central banks’ exposure to transition risks?

Risk management is also a key dimension of monetary policy implementation: it determines which assets central banks hold in their policy portfolios, and which ones they do not. Central banks usually set risk level thresholds for the assets that they purchase and accept as collateral in refinancing operations. The aim of such thresholds is to implement monetary policy while taking minimum risks on their balance sheets.

What about central banks’ exposure to transition risks then? Currently, central banks rely on the same risk metrics as financial markets to assess and manage their risk exposure. As argued above, these metrics very likely underestimate transition risks. Central banks’ balance sheets are thus likely to be much more exposed to transition risks than what appears on central banks’ risk monitoring metrics. This goes not only against central bank’s own risk policy and objectives but could also constitute a breach of their fiduciary duty to protect their balance sheet against undue losses.

Reflecting transition risks in central banks’ operations: a necessary and urgent step

To protect their balance sheets against transition risks unaccounted for by financial markets, central banks must enhance the risk metrics they currently use in monetary policy operations by adding a precautionary risk margin. This would reduce their risk exposure by, first, decreasing the share of asset purchases linked to firms exposed to transition risks, and second, by lowering the risk of the collateral that they accept in refinancing operations from such firms. Lower policy portfolio exposure to transition risks increases central banks’ resilience to transition shocks and protects central banks’ balance sheets from undue losses.

Such a policy has an additional benefit: it sets incentives to progressively align investment flows with a path towards a resilient and sustainable economy. Reducing the share of assets in monetary policy operations from firms exposed to transition risks — i.e. those relying mostly on business plans not aligned with a sustainable economy — would tighten their financing conditions. This means less and costlier funding for their activities and investments, which translates in the long-term into a shift in investments towards firms with more sustainable and resilient economic activities.

Originally published on the CEP website on July 10, 2020.



Council on Economic Policies

CEP is an international nonprofit nonpartisan economic policy think tank for sustainability.