Central banks are paying attention to climate-related financial risks. They are beginning to incorporate them into their financial stability and economic analysis, and in stress tests for banks.

It is also time for central banks to consider such risks when implementing monetary policy. This will be challenging. It requires more data relevant to the assessment of the climate change threat, a thorough methodology and, importantly, time.

In the implementation of monetary policy — which covers credit operations as well as asset purchases — thorough risk assessment is essential. It shields central banks’ balance sheets from potential losses and limits the risk in case of a counterparty default.

In doing so, central banks rely on internal as well as external expertise, particularly that provided by the major credit rating agencies which are already focusing on climate-related financial risks.

Many rating agencies already publish supplementary green scores as well as special environmental commentary. However, they have yet to come up with a comprehensive rating methodology that adequately captures the financial risks related to climate change, while also meeting evolving regulatory standards.

That is not a trivial exercise, given the lack of granular data covering the exposure of companies and industries to climate-related risks. Without historical evidence and the option of backward testing, it will be much harder to validate any new rating methodology.

What’s more, there is the horizon problem. Typically, credit ratings signal an expected probability of default over a period of between one and three years. Major climate risks, however, might not materialise for at least another decade. Others might become acute soon, as policymakers pressure companies to internalise the costs related to climate change.

What can central banks do to alleviate these difficulties? Unlike private sector banks, central banks follow the principle of “market neutrality”. This means that, when implementing monetary policy, they must not seek to distort markets’ price-discovery mechanism. Giving preferential treatment to certain industrial sectors or bowing to social pressure runs counter to this principle.

Nevertheless, central banks can act as catalysts, linking the eligibility of assets to climate-related reporting. For example, they could stop buying any securities from companies that do not disclose climate risks.

That would also have positive side effects. Tougher reporting requirements will boost the availability of data relevant to the climate-related risk assessment. Central banks should not stop there, however. They should apply the same logic to their internal credit ratings —for example, lowering companies’ credit scores in the case of a lack of transparency.

At the Bundesbank, we estimate a company’s one-year probability of default using a two-stage approach. First, we calculate a classification based on a range of accepted ratios (earnings before interest, taxes, depreciation and amortisation, for instance). Second, we examine additional qualitative information, including environmental, social and governance metrics. The Bundesbank also plans to add scenario analyses to its current approach, calculating the potential costs for companies of policy-driven changes (carbon taxes and so on).

There is no shortcut to developing a sound and consistent methodology for capturing climate risks. However, if central banks work together now, they will be able to better capture such risks when implementing monetary policy in years to come.