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Dr. Nasser S. Al-Mohannadi (Texas A&M University, Doha)

Prof. Dr. Olaf C.H.M. Sleijpen (DNB & Maastricht University)

Maastricht, 4 April 2016

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Agenda

• Why energy transition is relevant for central banks and financial supervisors• Possible scenario’s – likelihood of the carbon bubble• Impact on financial institutions• Policy recommendations• Concluding remarks• Suggestions for further research

This presentation is based on Al-Mohannadi (2015), Carbon Bubble Risks and Consequences for the Financial Sector, subsequent work by DNB and a DNB expert seminar on 8 February 2016.

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Background

• COP21: 195 countries; increase in temperature well below 2°

• FSB, Bank of England and ESRB demand attention for financial risks of energy transition

• Questions Dutch parliament regarding exposures Dutch financial institutions

• DNB: attention for long-term risks

Inquiry into the impact of ‘carbon bubble’ on Dutch financial sector

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How probable is a ‘carbon bubble’-scenario and what risks can materialize?

What are the exposures of the Dutch financial sector to CO2-intensive industries and what are

associated risks?

What are the implications for policy-makers, regulators, supervisors and financial institutions?

1 Scenarios

2 Exposure

3 Implications

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Gradual transition

Uncertainty regarding timing and pace energy transition leads to different scenarios

Abrupt transition

Climate

Economy

Technology

PoliticsDifferent interests and factors play a role with respect to a sustainable energy transition…

… leading to uncertainty regarding the timing and pace of energy transition

Four Possible Scenarios

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Scenario 1

Scenario 3Scenario 2

Scenario 4

Carbon Bubble

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1 TechnicalEfficiency Technology,, CO2 Capture and Storage,, Climate / Biodiversity, Water, Oil/Gas, Coal, Nuclear, Green Energy, Biomass (Biofuel)

Drivers: TECOP

3 Organizational

2OPEC, OECD, Taxes, Incentives, National Energy Companies, Individual, corporates/SME, Developed Countries, Developing Countries, Poor Countries, Land use, CO2 Trading/Market

4 Political

International Cooperation, Implementation, Efficiency Behaviour, Innovation

National Government, National Policies/Regulations, International Policies/Regulations, Energy Policies,Media, Countries, Regions, Agriculture biomass/biofuel producers, Environment Interests

1 TechnicalEfficiency Technology,, CO2 Capture and Storage,, Climate / Biodiversity, Water, Oil/Gas, Coal, Nuclear, Green Energy, Biomass (Biofuel)

Economic & CommercialOPEC, OECD, Taxes, Incentives, National Energy Companies, Individual, corporates/SME, Developed Countries, Developing Countries, Poor Countries, Land use, CO2 Trading/Market

4 PoliticalNational Government, National Policies/Regulations, International Policies/Regulations, Energy Policies,Media, Countries, Regions, Agriculture biomass/biofuel producers, Environment Interests

Impact/Probability Matrix

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Probability

Impa

ct

Scenario 1

Scenario 2

Scenario 3

Low

Med

ium

H

igh

Low Medium High

Scenario 4

Clim

ate

targ

et

not a

chie

ved

Clim

ate

targ

et

achi

eved

Carbon Bubble

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1 TechnicalEfficiency Technology,, CO2 Capture and Storage,, Climate / Biodiversity, Water, Oil/Gas, Coal, Nuclear, Green Energy, Biomass (Biofuel)

Causes of Carbon Bubble

3 Organizational

2OPEC, OECD, Taxes, Incentives, National Energy Companies, Individual, corporates/SME, Developed Countries, Developing Countries, Poor Countries, Land use, CO2 Trading/Market

4 Political

Lack of (coordinated) innovation

National Government, National Policies/Regulations, International Policies/Regulations, Energy Policies,Media, Countries, Regions, Agriculture biomass/biofuel producers, Environment Interests

1 TechnicalSharper than expected increase in average temperature

2 Economic & CommercialLack of carbon trading market (low carbon prices)

4 PoliticalLate government action to reduce CO2 emission (COP21 was about negotiation tactics with little intrinsic motivation)

Lack of technological progress (e.g. little development with respect to CCS)

Strong economic growth in particularly emerging markets, pushing the demand for energyValuation of energy companies under pressure climate risks

Lack of international cooperation

Abrupt government actions

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An abrupt transition does not only affect the fossil fuel industry

0 200 400 600 800 1000 1200 1400 1600 18000

2

4

6

8

10

12

14

19%

27%

19%

10%

19%

12%

Mining & quarrying

Electricity, gas, steam and air conditioning supply

Real estate

Agriculture

Manufacturing

TransportEmiss

ions

(100

tons

of C

O 2-e

quiv

alen

t)

Gross value added (GVA) (bln of €)

(*)

(*) ‘Real estate’ emissions include heating/airco by households

Source: Eurostat, Schoenmaker & Van Tilburg (2016)

CO2-emissions and size of sector (EU-27, 2012)

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Inquiry into the exposure of the Dutch financial sector to CO2-intensive industries so as to determine the vulnerability to a substantial depreciation of assets

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Feedback financial institutions

Gradual transition

• In general financial institutions regard the risk of a bursting of the ‘carbon bubble’ to be small• A gradual transition appears to be most likely. In this transition there will remain a need for fossil

energy sources, with a shift from coal to gas

Risk analysis• Climate risks are increasingly taken into account in decisions regarding new investments and

provision of credit• As regards existing investments, financial institutions try to influence CO2-intensive firms to change

their strategies towards a sustainable energy transition by means of stakeholder engagement

Sustainable energy

• Investments in sustainable energy projects are regarded as risky• Supply of these projects is limited and return dependent on government policy, which is regarded

as unpredictable• Current low prices for fossil fuels limit the incentives to invest

Valuation• Financial institutions use different methods to measure exposures, with large problems in terms of

quality and availability of data, as well as the underlying methods• There is a need for uniform standards

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Implications regulation, market and supervision (1/2)

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2

3

• Uniform standards regarding for instance the measurement of carbon footprints are necessary to adequately value climate risks

MEASURABILITY OF RISKS

PREDICTABLE GOVERNMENT POLICIES

• Consistent (and internationally coordinated) policy as regards both limitation of CO2 emission and promotion of the use of sustainable energy

CLIMATE RISK IN RISK MANAGEMENT

• Start with qualitative analysis• Quantitative analysis not yet possible due to lack of

information/ measurement standards

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Implications regulation, market and supervision (2/2)

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5• The financial sector can play a facilitating role in

the transition towards sustainable energy, for instance via stakeholder engagement

FACILITING ROLE FINANCIAL SECTOR

STRESS TESTS & CAPITAL

• Possibility of stress testing on the basis of better information/measurement of climate risks• Possibility of supervisors imposing capital requirements on the basis of stress test, if

required• Monitor concentration risks

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Conclusion- We face the future of TANIA (There Are No Ideal Answers) over the next 50 years

- A transition from CO2 intensive energy sources to less CO2 intensive sources appears likely and is already happening- … and will have a substantial impact on economies and hence financial institutions

- A gradual transition appears to be most likely, but a more shock-based adaptation can definitely not be excluded- … hence, financial institutions should take the “carbon bubble” in account in their risk

management

- Not to neglect, with technology successful progressions toward global warming adaptation, CO2 intensive energy sources can still be attractive- ….and economic development will continue to grow and have less of impact on financial

institutions

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Suggestions for further research• How to disclose climate-related risks in financial accounting? (Viz. FSB Task Force on Climate-related

Financial Disclosure)• Energy transition scenario’s – how to design stress test scenario’s for financial institutions?• How can climate-related risks be incorporated in risk management practices?• Liability risk of insurance companies (viz. PRA/Bank of England)• Impact of energy transition on financial stability• Energy transition and economic modelling

Questions?