Could climate change trigger a financial crisis?

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IN LAST YEARS Regulators are warning of the threat climate change poses to the stability of the financial system. Following its strategy review in July, the European Central Bank (ECB) will put together a “Climate Change Action Plan”. Mark Carney, the former governor of the Bank of England, warned in 2015 about financial risks from climate change. In America, the Commodity Futures Trading Commission last year published a 200-page report entitled “Climate change poses a major risk to the stability of the world US Financial system. “But progressive Democratic politicians are calling on President Joe Biden not to reappoint Jerome Powell as chairman of the Federal Reserve, partly because they believe he has done too little to eliminate climate risk.

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But how harmful is the climate risk? Early central bank stress tests and corporate disclosures are beginning to clear the issue. The evidence that it could crash the financial system is largely overwhelming. However, a lot depends on whether governments have a clear path to reduce emissions, such as through carbon taxes and energy efficiency standards, so that banks have enough time to prepare.

Climate change can affect the financial system in three ways. The first is through what regulators refer to as “transition risks”. These are most likely to occur when governments adopt tougher climate policies. When this is the case, the economy restructures: capital moves away from dirty sectors and towards cleaner ones. Companies in polluting industries can default on loans or borrowings; their stock prices can plummet.

The second channel is that financial firms are exposed to the dangers of rising temperatures. It is difficult to attribute individual natural disasters to climate change, but the Financial Stability Board, a group of regulators, estimates that global economic losses from weather-related disasters of 214 billion, roughly tripled as a share of the global one GDP. These losses are often borne by insurers (although the cost should be passed on to customers over time through higher premiums).

The financial system could also be exposed to greater economic damage from climate change, such as when it triggers fluctuations in asset prices. This third channel is harder to quantify. Scientific estimates of the effects of 3 ° C warming (compared to pre-industrial temperatures) differ from financial losses of around 2 to 25% of the world GDP, according to the Financial System Greening Network, a group of regulators. Even the bleakest estimate could turn out to be too rosy if climate change sparked conflict or mass migrations.

Perhaps the worst-case scenario for the financial system is that transition risks crystallize very suddenly and cause greater economic damage. In 2015, Carney described a possible “Minsky moment,” named after economist Hyman Minsky, when investor expectations about future climate policies adjust sharply, leading to distress sales of assets and widespread risk reassessment. That could lead to higher borrowing costs.

The value of financial assets exposed to transitional risk is potentially very high. According to Carbon Tracker, a climate think tank, roughly $ 18 trillion in global stocks, $ 8 trillion in bonds, and perhaps $ 30 trillion in unlisted debt are linked to high emitting sectors of the economy. This is comparable to the market for collateralised debt obligations valued at $ 1 trillion (CDOs) in 2007, which were at the center of the global financial crisis. However, the impact of losses depends on who owns the assets. For example, regulators may be particularly concerned about the risks of large, “systemically important” banks and insurers.

Preliminary central bank stress tests suggest that the effects of climate change on these types of institutions may be manageable. In April the Banque de France (B.D.F.) published the results of such an exercise. It found that French banks had little exposure to transitional risks. However, worsening droughts and floods in some regions more than five-fold increased claims on insurers.

In a recent article ECB and the European Systemic Risk Board came to similar conclusions. Bank and insurance exposures in the euro area to the most emitting sectors were “limited”, although losses were more severe in a “greenhouse world” scenario with a temperature rise of 3.5 ° C compared to pre-industrial times. In both cases, however, the banks ‘losses on their corporate loan books were only about half what they were in the regular euro area lenders’ stress tests, which were found to be adequately capitalized.

These findings are in line with an investigation by the Central Bank of the Netherlands (DNB) in 2018, when it was found that the impact of transition risks on Dutch financial firms was “manageable”. In the worst case scenario, there was a sudden change in climate policy and rapid progress in the expansion of renewable energies, which triggered a “double shock” and a severe recession for companies. Even then, banks’ equity ratios fell by around four percentage points. This is considerable, but still less than what banks saw in this year’s European Banking Authority’s regular stress tests, which they deemed to have passed.

To what extent are these stress tests realistic? Carbon Tracker’s Mark Campanale is skeptical, suggesting that most companies are using outdated models. Should auditors ever weigh on corporate assets in the face of much lower oil prices, the associated write-offs could trigger a dip in investor sentiment feared by regulators. The stress tests also do not include a full-blown Minsky crisis.

However, they are conservative in other respects. Most of the tests used an accelerated timeframe – five years a year DNB and B.D.F. Cases – assuming, in fact, that companies are stuck with the balance sheets they have today. However, it seems reasonable to assume that banks and insurers will change their business models in the course of the climate change and dampen the effects on the financial system. the B.D.F. conducted a second exercise that allowed companies to make realistic changes to their business models over a 30-year period. Unsurprisingly, this allowed banks to slash lending to fossil fuel sectors and insurers to raise premiums.

Nevertheless, the stress tests show the importance of giving companies time to adapt. And that makes a predictable path important for government policy. the B.D.F. found that credit losses were greatest when policies were delayed and a sudden transition occurred. Perhaps the most plausible scenario in which climate change affects financial stability is one in which governments dawdle 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 heading “Hot Take”

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