Could climate change trigger a financial crisis?
IN LAST YEARS regulators have begun to warn of the threat climate change poses to the stability of the financial system. Following its strategic review in July, the European Central Bank (BCE) develop a “climate change action plan”. Mark Carney, the former Governor of the Bank of England, warned of the financial risks of climate change as early as 2015. In America, the Commodity Futures Trading Commission released a 200-page report last year beginning with “Climate change poses a major risk to the stability of the we financial system. ”But progressive Democratic politicians are calling on President Joe Biden not to re-elect Jerome Powell as Federal Reserve chairman, in part because they believe he has done too little to eliminate climate risk.
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But how damaging can climate risk be? The first central bank stress tests and corporate statements are starting to shed light on the matter. For the most part, the evidence that it could bring down the financial system is disappointing. But a lot depends on whether governments have set a clear path to reducing emissions, for example through carbon taxes and energy efficiency standards, by giving banks enough time to prepare.
Climate change can affect the financial system in three ways. The first is through what regulators qualify as “transition risks”. These are more likely to occur if governments pursue more stringent climate policies. If they do, the economy restructures: capital moves away from dirty sectors and towards cleaner sectors. Companies in polluting industries can default on loans or bonds; the price of their shares could collapse.
The second channel is the exposure of financial companies to the vagaries of rising temperatures. Attributing individual natural disasters to climate change is tricky, but the Financial Stability Board, a group of regulators, estimates that global economic losses from weather disasters fell from $ 214 billion in the 1980s, at 2019 prices, to $ 1.62 billion in the 2010s, roughly tripling in proportion to the GDP. These losses are often borne by insurers (although over time the costs should be passed on to customers through higher premiums).
The financial system could also be exposed to wider economic damage from climate change, for example if it triggers asset price fluctuations. This third channel is more difficult to quantify. Academic estimates of the 3 ° C warming effect (relative to pre-industrial temperatures) deviate from financial losses by around 2% to 25% of the world GDP, according to the Network for Greening the Financial System, a group of supervisors. Even the bleakest estimate could prove to be overly optimistic if climate change triggers conflict or massive migration.
Perhaps the worst-case scenario for the financial system is where transition risks very suddenly crystallize and cause greater economic damage. In 2015, Mr Carney described a possible ‘Minsky moment’, named after Hyman Minsky, an economist, in which investor expectations about future climate policies adjust sharply, causing asset sales to burn and a fall. generalized reassessment of risk. This could translate into higher borrowing costs.
The value of financial assets exposed to transition risk is potentially very significant. According to Carbon Tracker, a climate think tank, around $ 18 billion in global equities, $ 8 billion in bonds and maybe $ 30 billion in unlisted debt are tied to high-emission economic sectors. . This compares to the $ 1 trillion market for secured debt securities (CDOs) in 2007, which were at the heart of the global financial crisis. However, the impact of losses would depend on the ownership of the assets. Regulators might be particularly concerned about the exposures of large “systemically important” banks and insurers, for example.
Preliminary stress tests conducted by central banks suggest that the impact of climate change on these types of institutions could be manageable. In April, the Banque de France (BDF) has published the results of such an exercise. It found that French banks‘ exposure to transition risks was low. Claims with insurers, however, have increased more than five times due to more severe droughts and flooding in some areas.
In a recent article the BCE and the European Systemic Risk Board found similar results. The exposures of banks and insurers in the euro zone to the most emitting sectors were “limited”, although the losses in a “greenhouse world” scenario where temperatures rise by 3.5 ° C compared to the time. preindustrial were more severe. Yet in both cases, banks’ losses on their corporate loan portfolios were only about half of those in regular stress tests of euro area lenders, which they were considered sufficiently well capitalized to pass. .
These conclusions are consistent with an exercise by the Dutch central bank (DNB) in 2018, who concluded that the impact of transition risks on Dutch financial firms was ‘manageable’. In its worst scenario, there has been a sudden change in climate policy alongside rapid progress in renewable energy development, causing a ‘double shock’ for businesses and a severe recession. Even then, banks’ capital ratios fell about four percentage points. This is considerable, but even less than what banks have experienced in the European Banking Authority’s regular stress tests this year, which they have been deemed to have succeeded.
How realistic are these stress tests? Mark Campanale of Carbon Tracker is skeptical, pointing out that most companies use outdated models. If auditors ever put corporate assets to the test of a much lower oil price, the associated write-downs could trigger a collapse in investor sentiment as feared by regulators, he says. Stress tests also don’t include a true Minsky crisis.
Yet in other respects they are conservative. Most of the tests used an accelerated timeframe – five years in the DNB and BDF case – actually assuming that companies are stuck with the balance sheets they have today. But it seems reasonable to think that banks and insurers will change their business models as the climate transition progresses, limiting the impact on the financial system. The BDF conducted a second exercise where companies were allowed to make realistic changes to their business models over 30 years. Unsurprisingly, this has allowed banks to sharply cut lending to the fossil fuel sectors and insurers to increase their premiums.
Nevertheless, stress tests reveal the importance of giving companies time to adapt. And that makes a predictable path for government policy important. The BDF found that credit losses were greatest when policy was delayed and there was a sudden transition. Perhaps the most plausible scenario in which climate change affects financial stability is one in which governments hang around and then have no choice but to take drastic action in the future. ■
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This article appeared in the Finance & economics section of the print edition under the title “Hot take”