"Make Finance be a Driver of Climate Mitigation and Adaptation"

In this interview, we talk to Irene Monasterolo, Professor of Climate Finance at EDHEC Business School and EDHEC-Risk Climate Impact Institute, about the reasons behind her decision to join EDHEC, climate change which represents a new type of risk for economic and financial stability, the climate stress-test of the financial system she co-developed, her recent participation in a COP26 side-event on the cascading impacts of natural disasters and her current and future research projects.

You joined EDHEC as professor of climate finance at the beginning of October 2021. Could we ask what motivated your choice of EDHEC?

Irene Monasterolo:

 I joined EDHEC to make an impact on the role that finance can play in the transition to a low-carbon economy, and in the achievement of the Paris Agreement climate targets. According to the last IPCC AR6 report, time is running out to achieve ambitious emissions reduction targets. We need a fast decarbonisation of the way we produce and consume, keeping fossil fuels in the ground. In this context, finance can make the difference for limiting the global temperature increase to 1.5° C compared to pre-industrial times. Indeed, the scale of this transformation requires a proactive role of finance, by mobilising investments in low-carbon activities. Here financial risk is key for capital reallocation because it drives financial actors’ investment decisions by increasing risk weights – and thus the cost of debt – for activities that are not aligned with the climate targets because they generate high levels of CO2. For this to happen, we need reliable metrics and methods to disclose and assess climate risks in investors’ portfolios. Such metrics and methods should be science-based and transparent to avoid greenwashing on the one hand, and a misunderstanding of the risks and opportunities on the other. Both would contribute to the failure of the low-carbon transition, with negative implications for ecosystems, socio-economic development and financial stability. This has been the focus of my research in recent years, in which I have developed climate-financial risk metrics and models to support financial actors in the assessment of risks and opportunities associated with climate scenarios and the low-carbon transition. My goal as a professor of climate finance is to produce mainstream research results on climate financial risk assessment for investors and financial authorities, supporting them in their climate financial risk management.

There is a growing awareness among central banks and financial regulators that climate change represents a new type of risk for economic and financial stability, what are your thoughts on this?

Irene Monasterolo:

Climate change represents a new type of risk for the economy and for finance. When we talk about climate, we should talk about tail risk. Climate change is characterised by non-linearity, tipping points that can lead to potentially irreversible changes in system earth dynamics, and by profound uncertainty (Monasterolo 2020). Importantly, as discussed in my recent article published in Science (Battiston et al. 2021), climate risk is endogenous, that is, the risk perception of the actors (e.g. investors, policy makers, households) in the system impacts the materialization of the risk itself. This is because the perception of climate risk across scenarios influences the climate policies and investment decisions that we may (or may not) take today, which in turn make the difference between achieving the low-carbon transition in an orderly or disorderly way, or even missing it. In addition, climate change does not happen in isolation but can compound with other sources of tail risk, such as pandemics. And when risks compound, the complexity of risk and the magnitude of losses increase, with implications for financial risk management, as I recently discussed on Brookings Institute’s blogs (Monasterolo et al. 2021).

The characteristics of climate risks open new challenges for financial analysis. If we want to be forward-looking with regard to climate risk, then past data (e.g. stock prices of high /low-carbon firms) alone won’t allow us to capture the exposure of investors to future climate physical and transition risks. For instance, we never had a low-carbon transition in the past, and so we cannot expect markets to fully price it. Moreover, we still do not know how the Earth system will respond to increases in CO2 emissions concentration above certain points (i.e. above 2° C), meaning that future climate impacts (and losses) could be much greater than expected. Thus, climate change poses important challenges for traditional financial risk metrics and hypotheses, e.g. market efficiency, smoothing their ability to inform investors and financial supervisors.

You have co-developed the climate stress test for the financial system, which embeds climate scenarios in asset pricing and investors’ risk assessment, can you tell us more about the methodology and who uses it?

Irene Monasterolo:

Climate financial risk assessment requires a tailored conceptual framework and tools that consider the nature of climate risk. Already in 2016, with a group of co-authors from the University of Zurich, Paris School of Economics and the Global Climate Fund, I co-developed the climate stress test for the financial system, which was published in Nature Climate Change in 2017. This test introduced the approach to integrating forward-looking climate mitigation scenarios, developed by process-based Integrated Assessment Models, into financial valuations (Battiston et al. 2017, Nature Climate Change) and portfolio analysis.

In particular, the climate stress test introduced the following methodological advances, which are included in the CLIMAFIN tool:

• The Climate Policy Relevant Sectors (CPRS), a standardized classification of economic activities at high granular level (e.g. NACE Rev2 4-digit codes) according to their exposure to climate transition risk, in order to quantify carbon-stranded assets in investors' portfolios. Importantly, the CPRS do not consider only GHG emissions but also key dimensions of the alignment of firms with the low-carbon transition scenarios, i.e. their energy technology profile, revenues and business model in terms of input substitutability;
• Climate-adjusted financial valuation models for financial contracts and securities (equity, bonds, loans);
• Climate-adjusted financial risk metrics (e.g. the climate VaR);
• A balance sheet stress test based on financial network models (Battiston et al. 2012) to consider the role of financial interconnectedness (e.g. second, third-round effects, etc.) on the reverberation of losses and the conditions for systemic financial risk.

Together with my co-authors, we collaborated with several central banks, financial regulators and investors in the EU, US and Switzerland, supporting the application of our methodology to disclose and assess investors’ exposure to climate physical and transition risks. In the EU, for instance, the European Central Bank, the European Banking Authority, the European Insurance and Occupational Pension Authority, the European Securities and Market Authority, and the European Commission, to name a few, used the Climate Policy Relevant Sectors to analyse investors’ exposure to climate transition risk.

Recently, you co-organised and chaired a COP26 virtual side-event on cascading climate risks for investors and supervisors, what were the main issues examined?

Irene Monasterolo:

Growing climate change and a potentially disorderly transition to a low-carbon economy introduce new sources of risk for countries’ economic and financial stability. On the one hand, extreme weather events and chronic temperature increases can damage physical assets leading to indirect economic impacts (i.e. losses in firm profitability, employment, GDP) and cascading social and financial impacts (i.e. migration and poverty, and increasing credit risk and financial losses for investors, respectively). For instance, by affecting production plants in the industrial areas of a country that is highly integrated in the global value chain, natural hazards can trigger cascading risk for the country’s trading partners and investors (e.g. in the EU). On the other hand, late and uncoordinated introduction of climate policies and technology disruptions, whose impacts cannot be fully anticipated by investors, may give rise to carbon-stranded assets, with indirect economic impacts (e.g. on investments) and cascading impacts on financial stability.

Understanding through which channels climate risks can cascade onto agents and sectors of the economy and finance, and the drivers of potential shock amplification, is crucial for risk assessment as well as to strengthen fiscal and financial risk management. The direct, indirect and cascading impacts that could unfold are influenced by country-specific drivers of exposure and structural characteristics, and can compound with other sources of stress. However, financial industry players and policy makers still lack a coherent framework and the tools to assess the macro-financial criticality of cascading climate risks to their business, and to adapt risk management.

As part of the COP26 Finance Day, I had the pleasure to moderate the discussion about the drivers and implications of cascading climate risks for macroeconomic and financial stability. I was joined by a high-level panel of experts made up of representatives of international financial institutions and the financial industry, IPCC lead authors and academics to discuss the issues at stake and opportunities ahead. In particular, our session addressed the following questions:

• Through which channels can climate risks cascade onto financial actors’ balance sheets and financial stability?
• Do we have the right tools to assess these?
• Could cascading risks be integrated into the financial risk management of financial actors and supervisors, and what are the implications for financial regulation?

Could we ask about your current research ? What themes are you working on at the moment?

Irene Monasterolo:

My current research focuses on the role of finance – tools, instruments and policies – in the low-carbon transition.

In particular, I am working on three streams of research:

1/ The analysis of the role of investors’ climate sentiments on the realisation of climate mitigation scenarios, such as those developed by the Network for Greening the Financial System (NGFS), to identify under which conditions finance can enable or hinder an orderly transition. As introduced in the article that I published this year in the Journal of Financial Stability (Dunz et al. 2021a), and the recent paper in Science (Battiston et al. 2021), investors can have climate sentiments that depend on their expectations about the realisation of climate scenarios and their impacts. This, in turn, can lead them to adjustments in the cost of capital and debt financing of firms depending on their exposure to climate physical and transition risks. I am extending this research by modelling and empirically validating, in collaboration with financial actors, the role of investors’ climate sentiments in the realization of the NGFS climate scenarios, developing a dynamic climate stress test model. This helps endogenize the orderly and disorderly characteristics of the transition, thus strengthening the assessment of climate-related financial risks and opportunities. With this research, I aim to better inform climate financial risk assessment, as well as the design of macroprudential regulations to mitigate such risks.

2/ The assessment of the macroeconomic and financial impacts of climate change, accounting for the compounding of climate risks with pandemics, and tail risk, building on the results of the collaboration with the World Bank (Finance, Competitiveness and Innovation Unit, Mahul et al. 2021). Traditional macroeconomic models, including those used by central banks, rely on strong assumptions about an agent’s perfect foresight and representativeness, equilibrium and market efficiency, which do not hold in the context of profound uncertainty and non-linearity of climate risks. To complement such models, we built EIRIN (Monasterolo and Raberto 2018, Dunz et al. 2021b), a Stock-Flow Consistent behavioural model, with heterogenous, interacting agents and sectors of the economy and finance, that is not constrained to solve to equilibrium; it allows agents to depart from perfect foresight and to endow adaptive expectations. We will account for the finance–economy interactions (e.g., bank lending conditions) that affect economic and financial agents’ responses in times of crisis, to improve our understanding of how and why individual and compounding shock impacts tend to amplify, possibly generating contagion.

3/ Finally, I am completing the analysis of the double materiality of climate risks in the EU economy and banking sector, which I developed with a team of researchers at WU Wien and the University of Venice, in collaboration with Laura Parisi from the European Central Bank (Gourdel et al. 2021). The existence of double feedback between climate change and the financial system, i.e. the impact of climate risks on financial stability, and the impact of financial actors on climate scenarios, has been recently recognized by policy makers and financial supervisors, and this feedback loop is known as the ‘double materiality of climate risks’. While recent studies have helped understand the implications of climate scenarios in the economy and finance, a methodological framework to assess the double materiality of climate risks is not yet available. To this end, I have contributed to the development of a dynamic macro-financial assessment of the NGFS climate scenarios by tailoring the EIRIN model. We quantitatively assessed the feedback from banks’ expectations about investment risk across NGFS scenarios, and risk internalization, on firms’ capital costs and performance, on the decarbonization of the economy and on banks’ lending, and on the realization of the same climate mitigation scenarios.

References

Battiston S., I. Monasterolo, K. Riahi & B. van Rujiven (2021). Accounting for finance is key for climate mitigation pathways. Science, 372(6545), 918-920. DOI: 10.1126/science.abf3877

Battiston S., A. Mandel, I. Monasterolo, F. Schuetze & G. Visentin (2017). A Climate stress-test of the EU financial system. Nature Climate Change, 7, 283–288. DOI: https://doi.org/10.1038/nclimate3255

Dunz, N., A. Mazzocchetti, I. Monasterolo, A. Essenfelder & M. Raberto (2021b). Compounding COVID-19 and climate risks: the interplay of banks’ lending and government’s policy in the shock recovery. Journal of Banking and Finance, 106303. DOI: https://doi.org/10.1016/j.jbankfin.2021.106306

Dunz, N., A. Naqvi, I. Monasterolo (2021a). Climate sentiments, transition risk, and financial stability in a stock-flow consistent model. Journal of Financial Stability, vol. 54, June 2021. DOI: https://doi.org/10.1016/j.jfs.2021.100872

Gourdel, R., I. Monasterolo, N. Dunz, A. Mazzocchetti & L. Parisi (2021). Assessing the double materiality of climate risks in the EU economy and banking sector. ECB working paper, forthcoming (Nov. 2021), available at SSRN (https://bit.ly/2YWrRcA)

Mahul, O., I. Monasterolo & N. Ranger (2021). Learning from COVID-19 and climate change: Managing the financial risks of compound shocks. World Bank blog, https://bit.ly/3zYqTdV

Monasterolo, I., N. Dunz A. Mazzocchetti & A. Essenfelder (2021). Financial risk assessment and management in times of compounding climate and pandemics shocks. Brookings Institute, Future Development: https://www.brookings.edu/blog/future-development/2021/10/22/financial-risk-assessment-and-management-in-times-of-compounding-climate-and-pandemic-shocks/

Monasterolo, I. (2020). Climate change and the financial system. Annual Review of Resource Economics, Volume 12, 1-22. DOI: https://doi.org/10.1146/annurev-resource-110119-031134

About Irene Monasterolo

Irene Monasterolo is Professor of Climate Finance at EDHEC Business School and Research Programme Director at EDHEC-Risk Climate Impact Institute in Nice (FR) and senior research fellow at the Vienna University of Economics and Business (Austria) and Boston University (USA), as well as visiting scholar at the International Institute for Applied Systems Analysis (Austria). Irene holds a PhD in Agri-food economics and statistics from the University of Bologna (IT) and two post doctoral experiences in Cambridge (UK) and Boston University (USA), on climate finance.

Irene’s research is contributing to understand the role of finance in the achievement of the climate targets in both high income and developing countries, and the assessment of climate-financial risks and opportunities in the low-carbon transition. She has co-developed the climate stress-test of the financial system, which embeds climate scenarios in asset pricing and investors’ risk assessment, and was published in Nature Climate Change and Science. The Climate Stress test methodology included in the CLIMAFIN tool has been applied by several (public and private) financial institutions to assess investors’ exposure to climate physical and transition risks.

Irene has also co-developed the EIRIN Stock-Flow Consistent macro-financial model to analyse the implications of climate policies (fiscal, monetary, prudential) on green investments, financial stability and inequality. Currently, with the EIRIN model, Irene is supporting the World Bank in the analysis of the macro-financial criticality of compounding COVID-19 and climate risk ,and is collaborating with the European Central Bank at the analysis of the double materiality of climate risk in the EU economy and banking sector (forthcoming as European Central Bank working paper).

Irene is contributing to the G24 V20 countries’ Task Force on Climate, Development, and the IMF led by Boston University’s Global Development Policy Center, as well as to the World Bank’s Crisis Risk Analytics project of the Global Risk Financing Facility aimed to assess the macroeconomic and financial implications of compounding COVID-19 and climate physical risks.

Irene’s research has been published on leading academic journals, such as Science and Nature Climate Change, as well as on non-academic journals (e.g. Le Monde, UNPRI). She has co-edited the first special issue on Climate Risks and Financial Stability (published on Journal of Financial Stability in 2021). Irene has co-authored the G20’s T-20 chapter on Sustainable Finance, and climate finance chapters of the Financial Stability Review of the European Insurance and Occupational Pension Authority (EIOPA) and of the Austrian National Bank (OeNB).