Climate change uncertainty and central bank risk management

Abstract

The drastic change in the Earth’s climate is a key concern for central bank risk managers. The consequences of climate change for the economy are harmful and potentially far-reaching. Central banks are exposed to climate change through their asset purchase programmes and credit operations and via the impact of climate change on the economy in general. Risk management in this case is challenging and complex because climate change is surrounded by fundamental uncertainty. Given this fundamental uncertainty, risk managers can however rely on the precautionary principle for practical purposes. This principle aims to anticipate and minimise the potential impact of serious or irreversible events under conditions of uncertainty. Stronger risk mitigating measures taken at an early stage serve as a hedge against the cost of enduring temporary catastrophes or draconian interventions at a later stage. This paper discusses the fundamental uncertainty of climate change and offers some recommendations for the identification, assessment, mitigation and disclosure of climate change uncertainty in central bank risk management. These recommendations are however equally relevant for commercial banks and institutional investors.