Climate change has the potential to wipe out trillions of pounds worth of assets. The alarm bells are beginning to ring in the financial world, and central banks are beginning to catch-on.
Bank of England Governor Mark Carney recently warned of the “catastrophic impacts” climate change could have for our financial system. According to Carney, the climate risks we are facing are so severe that they could result in a ‘climate Minsky moment’ involving a rapid, system-wide collapse in asset prices.
The most visible source of risk from climate change is physical– the increased frequency and severity of extreme weather events – with the potential to disrupt global supply chains, resource availability, and entire industries.
The less obvious, more immediate threats lie in how we transition towards a low carbon economy – the transition risks. These risks arise from the processes of mitigation and adjustment towards a lower-carbon economy, which are likely to have significant effects on carbon-intensive sectors.
Deflating the carbon bubble
A successful green transition means re-aligning finance and capital to a more ecologically sustainable footing. However, it also means deflating potentially the biggest asset price bubble in history: the carbon bubble.
Forecasts suggest that only one quarter of remaining fossil fuel reserves can be burned if we are to keep to the Paris Climate Agreement and stop temperatures rising above 2°C. Leaving most of the world’s oil, gas and coal in the ground means carbon intensive assets may be grossly overpriced, and infrastructure built to extract the reserves may become useless (known as ‘stranded assets’).
Carbon intensive businesses risk huge losses because their activities and market value are still partly dependent on the assumption that what environmental campaigners call ‘unburnable carbon’ will nonetheless still be extracted. These losses could reverberate through the financial system, with approximately 30% of the market value of the FTSE 100 stock exchange directly derived from oil, gas and mining companies.
The impacts will not be limited to the fossil fuel sector alone, but will also indirectly affect industries that use carbon intensive inputs in their production. This could lead to losses of between 45% and 60% of the value of equity portfolios; and up to $43 trillion of losses to the total global stock of assets by the end of the 21st century.
By extending credit to carbon intensive companies, the banking sector is also exposed to these risks. While banks might not default due to their direct exposure to fossil and utilities sectors, it is the indirect exposure to sectors dependent on fossil fuels that could eat up between 40% and 280% of their capital – the latter figure would effectively bankrupt the banking sector almost three times over.
A bolder policy response
Central banks have taken some commendable steps to address financial climate risks. Most notably, G20 central banks and finance ministers have established the Task Force on Climate-related Financial Disclosures (TCFD).
The TCFD initiative encourages the voluntary public disclosure of climate and carbon risks both businesses and financial institutions. In theory, greater transparency would allow the market to price in risks, enabling the efficient flow of capital.
The response from central banks is welcome, but if we are serious about tackling climate change and its risks to financial stability, we need a much bolder policy approach.
In fact, many central banks’ portfolios are also highly skewed towards carbon intensive sectors, leaving them exposed to climate risks. Yet central banks have so far been unwilling to walk the talk and transparently disclose their own exposure. Can we really expect private institutions to make these disclosures when leading public institutions are unwilling to do so?
At the New Economics Foundation, we are calling on central banks to be coherent in their policy approach and disclose the financial implications and risks of climate change on their own balance sheets.
But: while we need greater transparency from all banks, relying on the efficiency of markets will not be enough address the challenge we face. The 2008 global financial crisis was a crude awakening to what happens when we depend on the efficiency of markets and their ability evaluate risk.
In response to the 2008 crash, central banks upgraded their toolkits and took a new approach: ‘macroprudential policy’. This approach is based on the recognition that, left to their own devices, markets will fail to price assets and risks efficiently. These failures lead to the build-up of economy-wide systemic risks – like the build-up of mortgage debt and house prices relative to incomes in the run up to 2008.
Macroprudential policy gives central banks powers to reign in those activities that lead to bubbles, cyclical swings and economic shocks. A number of central banks are now using these tools to thwart systemic risks from the real estate sector. Shouldn’t the same logic be applied to risks posed by the carbon bubble?
Many financial supervisors are already conduct banking stress tests, to gage how the banking sector as a whole would cope with hypothetical adverse scenarios, such as severe recessions or financial crises. As François Villeroy de Galhau, head of the French central bank, recently suggested, central banks could run climate stress-tests to measure the banking system’s exposure to climate risks.
To mitigate any systemic risks, brown capital requirements could be introduced, e.g. for loans carrying carbon risk, or entities that are severely reliant on fossil fuels. This would reflect the growing systemic risk of investing in carbon intensive activities, and could discourage lending that contributes to climate change. It would also give banks a buffer to withstand carbon bubble-related losses and the repricing of stranded assets.
To do this, central banks need more support from policy makers. The carbon bubble needs deflating, and we must deploy the necessary policy tools to facilitate a green transition, while ensuring financial stability.
Public policy makers need to work with them to make sure we start exiting high carbon assets now and develop a transition plan for people working in carbon intensive industries. If not, climate change could make the devastation of the 2008 financial crisis seem like a walk in the park.