While the EU scales up efforts to foster sustainable finance, the MFSA Greens up too!

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Giorgia Conte Analyst – Financial Stability, MFSA

While the world is still focused on the consequences of the COVID-19 pandemic, the Sustainable Finance front offers some good news.

Over the past few months, considerable progress has been made in achieving the 2050 Carbon Neutrality targets, set by the Paris Agreement (2015). Within the European Union (EU), the European Commission (EC) has made significant progress in the achievement of milestones and objectives set out in the Sustainable Finance Action Plan.

In this regard, the Sustainable Finance Technical Expert Group published a report on EU taxonomy, while providing further guidelines about EU green bonds. The established taxonomy constitutes an essential tool to channel capital flows towards sustainable initiatives. Through this framework, it will be easier for investors to identify those assets which have a lower carbon footprint and support the promotion and issuance of green instruments.

Growth in the use of such instruments is considered to be a key aspect to achieve progress in the area of sustainable finance.

In addition, the EC finalised a first consultation document on the sustainable finance strategy to be adopted as part of the EU Green Deal. In this consultation document, the EC is presenting its proposed plan on how to achieve a sustainable economy within the EU. The European Central Bank (ECB) and the European Supervisory Authorities (ESAs) have also shown their commitment to support the Commission in the pursuance and adoption of the sustainable finance strategy. This was reflected in the establishment of specific working groups which aim to enhance cooperation with National Competent Authorities (NCAs) on sustainability and climate change related matters and initiatives.

On the domestic front, the MFSA has also clearly defined its intentions on sustainable finance. Indeed, as part of its “Supervisory Priorities 2020”, the MFSA is taking part in a number of initiatives at EU level and has also set up a cross-functional Internal Committee on Sustainable Finance to ensure a uniform approach across sectors and business lines. Furthermore, given the MFSA’s ambition to become an active catalyst of sustainable change within the financial sector – both domestically and internationally, the MFSA has recently joined the Network for Greening the Financial System (NGFS). The NGFS is composed of global members from Central Banks and Supervisory Authorities cooperating and sharing knowledge to address climate change and scale up sustainable finance. Through this membership, the MFSA will have the opportunity  to not only access, but also to contribute to specialised research while ensuring the necessary support to a transition towards a greener future.

 Climate Change and Financial Stability

In line with the Authority’s Strategic Plan 2019-2021, the Financial Stability function within the MFSA has taken an active role in the development of the necessary expertise to understand better the major risks that the domestic economy may be exposed to, as a result of climate change.

Climate change is considered relevant from a financial stability perspective, owing to two main risks: physical and transition risks.

More frequent extreme weather events, such as floods and droughts, directly expose financial institutions to what is known as physical risk.  Extreme weather conditions may directly impinge on the financial sector through a contraction in profitability due to increases in impairments and reduced revenues. 

In the insurance sector, this would result in a surge in weather-related claims, as these are generally covered by insurance policies. However, climate-related events may indirectly influence the financial sector, through the contractions created in economic activity. At the same time, preventing physical risks from materialising, by enhancing the transition towards a green economy, generates another major risk for financial stability: transition risk.

This risk is triggered by the collective efforts to address sustainability concerns within economies (through new regulations, the introduction of new technologies and the shifts in consumer sentiment). As a result of such green initiatives, demand for carbon-intensive products could drop, resulting in asset prices related to carbon-intensive sectors to abruptly fall, ultimately leading to disruptions in financial markets.

At first glance, it may appear that in this transition to a greener economy, risks would only be localised in carbon-intensive industries. However, this may not be necessarily the case, given the financial sector’s exposure to these sectors, as well as the interconnectedness present between institutions within the financial sector. As a result, from a financial stability perspective, it is vital to clearly understand the implications of this phenomenon for the economy.

To this end, in the coming months, the Financial Stability function within the MFSA will be engaging in forward-looking risk assessments methodologies to anticipate financial stability risks caused by climate change risks in order to prevent them from escalating.