Finance, climate-change and radical uncertainty: Towards a precautionary approach to financial policy

TLDR

Climate‑related financial risks are now recognised by central banks and supervisors, yet current policy mainly relies on market‑based tools such as disclosure, transparency, scenario analysis and stress testing. The authors propose a precautionary financial policy framework to legitimize more ambitious interventions for long‑term climate risks. The framework combines the precautionary principle with modern macroprudential policy to fully integrate climate‑related financial risks into prudential, macroprudential and monetary policy. They argue that market‑based solutions are ineffective under radical uncertainty and bias policy toward short‑term market stability at the expense of long‑term catastrophic climate risks.

Abstract

Climate-related financial risks (CRFR) are now recognised by central banks and supervisors as material to their financial stability mandates. But while CRFR are considered to have some unique characteristics, the emerging policy framework for dealing with them has largely focused on market-based solutions that seek to reduce perceived information gaps that prevent the accurate pricing of CRFR. These include disclosure, transparency, scenario analysis and stress testing. We argue this approach will be limited in impact because CRFR are characterised by radical uncertainty and hence 'efficient' price discovery is not possible. In addition, this approach tends to bias financial policy towards concern around avoiding short-term market disruption at the expense of longer-term, potentially catastrophic and irreversible climate risks. Instead, an alternative 'precautionary' financial policy approach is proposed that offers an intellectual framework for legitimizing more ambitious financial policy interventions in the present to better deal with these long-term risks. This framework draws on two existing concepts — the 'precautionary principle' and modern macroprudential policy — and justifies the full integration of CRFR into financial policy, including prudential, macroprudential and monetary policy frameworks.