climate systemic risk central banks and the climate

Climate systemic risk

Central banks and the climate fragility

hypothesis

December 12, 2019

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Introduction

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Future of economic activity and emissions …

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Sources: Intergovernmental Panel on Climate Change (IPCC) Fifth Assessment Report scenario database, 1.5 °C scenarios from scientific literature (see footnote 19), IPCC historical emission database and intended nationally determined contribution quantification

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… and a diversity of impacts …

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… and a diversity of impacts …

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Which theoretical framework for central

banks, regulators and supervisors?

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Price the externality

The standard climate-economy nexus

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The problem(s) with IAMs

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Economy

Atmospheric

temperature

Oceanic

temperature

Deep ocean

Carbon cycle

GHG emissions

Radiative

forcing

Damages

Atmosphere

Biosphere and surface

ocean

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A strong uncertainty over optimal carbon values …

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Source : Moyer et al. (2014)

Source : Stern and Stiglitz

(2017)

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… Coming mainly from uncertainty about discount rate …

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In 2300, +6°C and a very marginal

impact on GDP!!!

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… And the form of the damage function

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Or forced degrowth before the end of the

century?

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The problem(s) with IAMs

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Economy

Atmospheric

temperature

Oceanic

temperature

Deep ocean

Carbon cycle

GHG emissions

Radiative

forcing

Damages

Atmosphere

Biosphere and surface

ocean

A single tool: the unique optimal carbon price

No role for central banks (except through usual

inflation targeting), regulators or supervisors

Strong uncertainties on pricing the future and the for

of the damage function

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Monetary policy and climate change

o Supply-side shocks (McKibbin, 2017):

• might affect central banks’ price stability mandate (through

agricultural and energy products mainly)

• after extreme events in the SR,

• but also by reducing productive capacity in the LR

o Demand shocks:

• investment or consumption behaviours are changed with uncertain

impacts

o Price and output may go in different directions, letting the CB to

choose between two essential objectives (Debelle, 2019)

o BUT:

• Climate change is not a cyclical phenomenon (Coeuré, 2018)

Climate change might induce supply and demand side

shocks

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The difficult risk management

approach

The « greatest market failure the world

has ever seen » (Stern, 2007)

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A need to explicitly represent financial actors

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Economy

Atmosphere

Deep ocean

Carbon cycle

GHG emissions

Radiative

forcing

Damages

Finance Biased financing decisions

Atmospheric

temperature

Oceanic

temperature

Biosphere and surface

ocean

Imperfectly anticipated damages

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An important precursor

Mark Carney: climate change is a « tragedy of the horizons »

(Sept. 2015) for the financial system

o Monetary policy: 2-3 years

o Financial stability: 5-10 years

o Climate change: 2030, 2050, 2100

‘..once climate change becomes a defining issue for financial

stability, it may already be too late’

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Physical risks

« those risks that arise from the interaction of climate-related hazards

[…] with the vulnerability of exposure to human and natural systems »

(Batten et al., 2016)

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Transition risks

risk associated with a massive shift from carbon-intensive (or brown)

assets to greener ones

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Source : Dietz et al (2016)

Source : Battiston et al. (2017)

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Legal risks

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Source : Heede (2014)

Source : Munich Re (2010)

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A need to explicitly represent financial actors

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Economy

Atmospher

e

Deep ocean

Carbon cycle

GHG emissions

Radiative

forcing

Damages

Finance Biased financing decisions

Atmospheric

temperature

Oceanic

temperature

Biosphere and surface

ocean

Imperfectly anticipated damages

The single carbon price tool cannot be achieved for

eco/social reasons

Target a thin path between transition and physical risks

A natural role for central banks, regulators and supervisors

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Climate change as a threat to financial stability

Channels (DG treasury, 2017): • Credit risk:

borrower’s ability to repay their debt, leading to higher probability of

default

Potential depreciation of assets used for collateral could increase credit

risk

• Market risk:

Fire-sale of assets due to rapid transition and/or physical exposure

• Liquidity risk:

Difficult refinancing of banks in the SR, leading to tensions on the interbank

lending market

• Operational risk:

Direct exposure of financial institutions to physical risks

Channels

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Institutional initiatives

• FSB : Task Force on Climate related Financial Disclosure • Voluntary information related to climat change (december 2016

report)

• G20 : Green Finance Sub Group (GFSG) directed by BoE

and PBoC • Recommandations on greening the banking system, institutional

investors, on the risk analysis and the measure of progress

• Studies by central banks and prudential authorities:

• De Nederlandsche Bank, Swedish Financial Supervisory

Authority, UK Prudential Regulation Authority, Banque de France,

Banque du Liban, …

• Creation of the NGFS

Tools

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Institutional initiatives

• FSB : Task Force on Climate related Financial Disclosure • Voluntary information related to climat change (december 2016

report)

• G20 : Green Finance Sub Group (GFSG) directed by BoE

and PBoC • Recommandations on greening the banking system, institutional

investors, on the risk analysis and the measure of progress

• ESRB: 2016 report on the systemic carbon risk for EU

• Studies by central banks and prudential authorities:

• De Nederlandsche Bank, Swedish Financial Supervisory

Authority, UK Prudential Regulation Authority, Banque de France,

Banque du Liban, …

• Creation of the NGFS

Tools

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Axis 1 : restore market efficiency : - Transparency of information

- Support to the development of green bonds

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Institutional initiatives

Tools

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Source: ESRB (2016)

Source: UK Prudential regulation authority (2015)

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Institutional initiatives

Tools

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Source: ESRB (2016)

Source: UK Prudential regulation authority (2015)

Axis 2 : acknowledgement of the impossible diversification of climate risk and need to use:

- Climate stress-tests

- Climate related macroprudential policies

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o BUT:

• The combination of risks and the related uncertainties probably make the risk management approach insufficient (Aglietta and Espagne, 2016)

• Climate change calls for measures to hedge against fat-tail climate

risks (Weitzman, 2009)

o The combination of risks may lead to a « climate Minsky

moment » (Carney, 2015; Pereira da Silva, 2019).

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The climate fragility hypothesis

More than a market failure

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Legal risk

Extreme events

Climate fragility Financial fragility

Biochemical uncertainties

Carbon risk

Atmospheric

temperature

Température

océanique

Atmosphere

Deep

ocean

Carbon cycle

GHG emissions

Radiative forcing

Damages

Biosphere and surface ocean

Finance Economic agents

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Monetary policy

Wrongly anticipated damages

Financing decision

Climate fragility Financial fragility

Financial cycle

Financial regulation

Atmospheric temperature

Température

océanique

Atmosphere

Deep ocean

Carbon cycle

GHG emissions

Radiative forcing

Damages

Biosphere and surface ocean

Finance Economic agents

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Financial cycle and technical system

An institutional mismatch between the financial structure

and the (required) technical system

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Type

d’innovation

Émergence Diffusion Crise

d’adaptation

Maturité Période

totale

Machine à

vapeur et

textiles

1762-1774 1794-1834 1834-1843 1844-1861 1762-1861

Rail et

sidérurgie

1831-1847 1847-1888 1888-1895 1896-1917 1831-1917

Production de

masse

1882-1908 1908-1937 1937-1949 1950-1973 1882-1973

Information et

communication

1961-1981 1981-2000 2000-2013 2013- ? 1961- ?

Environnement 1972-2015 2015- ? ? ? ? ? 1972- ?

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Financial cycle and technical system

An institutional mismatch between the financial structure

and the (required) technical system

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Type

d’innovation

Émergence Diffusion Crise

d’adaptation

Maturité Période

totale

Machine à

vapeur et

textiles

1762-1774 1794-1834 1834-1843 1844-1861 1762-1861

Rail et

sidérurgie

1831-1847 1847-1888 1888-1895 1896-1917 1831-1917

Production de

masse

1882-1908 1908-1937 1937-1949 1950-1973 1882-1973

Information et

communication

1961-1981 1981-2000 2000-2013 2013- ? 1961- ?

Environnement 1972-2015 2015- ? ? ? ? ? 1972- ?

A multiplicity of (technical) equilibria can arise in the long run.

Debt dynamics and the financial system as a whole play a key

role in discriminating between the possible futures.

Calls for a much more proactive role of central banks,

supervisors and regulators

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Policy consequences

More than a market failure (Svartzman et al., 2019)

o The social cost of carbon does not imply a single carbon tax

tool, but could be translated into a more complex policy mix

combining monetary, prudential and fiscal instruments

(Krogstrup and Oman, 2019):

• Increased role for fiscal policy, especially at the zero lower bond (« green new deal » and beyond)

• Increased cooperation on climate issues among international financial authorities (NGFS, Coalition of finance minister for climate action, Basel committees, …) for strengthened regulations and carbon valuation tools (SCC, value of avoided emissions, …)

• Systematic integration of climate and sustainibility in corporate and national accounting.

o The debt emitted by the central bank is the ultimate asset

provider for private and economic actors.

• CB as a collective insurer within the LCT dynamics?

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Bibliography

Aglietta, M., & Espagne, É. (2016). Climate and Finance Systemic Risks, More Than an Analogy?: The Climate Fragility Hypothesis. CEPII, Centre d'etudes prospectives et d'informations internationales.

Batten, S., Sowerbutts, R., & Tanaka, M. (2016). Let's talk about the weather: the impact of climate change on central banks.

Battiston, S., Mandel, A., Monasterolo, I., Schütze, F., & Visentin, G. (2017). A climate stress-test of the financial system. Nature Climate Change, 7(4), 283.

Carney, M. (2015). Breaking the Tragedy of the Horizon–climate change and financial stability. Speech given at Lloyd’s of London, 29, 220-230.

Cœuré, B. (2018, November). Monetary policy and climate change. In Speech by Benoit Coeuré, Member of the Executive Board of the ECB, at a conference on “Scaling up Green Finance: The role Central Banks”, Berlin (Vol. 8).

Debelle, G. (2019, March). Climate Change and the Economy. In Public Forum hosted by the Centre for Policy Development, Sydney (Vol. 12).

Dietz, S., Bowen, A., Dixon, C., & Gradwell, P. (2016). ‘Climate value at risk’of global financial assets. Nature Climate Change, 6(7), 676.

Gros, D., Lane, P. R., Langfield, S., Matikainen, S., Pagano, M., Schoenmaker, D., & Suarez, J. (2016). Too late, too sudden: Transition to a low-

carbon economy and systemic risk (No. 6). Reports of the Advisory Scientific Committee.

Heede, R. (2014). Tracing anthropogenic carbon dioxide and methane emissions to fossil fuel and cement producers, 1854–2010. Climatic Change, 122(1-2), 229-241

Krogstrup, S., & Oman, W. (2019). Macroeconomic and Financial Policies for Climate Change Mitigation: A Review of the Literature. International Monetary Fund.

McKibbin, W. J., Morris, A. C., Panton, A., & Wilcoxen, P. (2017). Climate change and monetary policy: Dealing with disruption.

Moyer, E. J., Woolley, M. D., Matteson, N. J., Glotter, M. J., & Weisbach, D. A. (2014). Climate impacts on economic growth as drivers of uncertainty in the social cost of carbon. The Journal of Legal Studies, 43(2), 401-425.

P.R Authority (2015). The impact of climate change on the UK insurance sector. A Climate Change Adaptation Report.

Pereira da Silva, L. (2019). Research on climate-related risks and financial stability: an ‘epistemological break’?. In Conferencia pronunciada en la Conferencia del NGFS (Vol. 17).

Stern, N., & Stern, N. H. (2007). The economics of climate change: the Stern review. cambridge University press.

Stiglitz, J. E., Stern, N., Duan, M., Edenhofer, O., Giraud, G., Heal, G. M., ... & Shukla, P. R. (2017). Report of the high-level commission on carbon prices.

Svartzman, R., Dron, D., & Espagne, E. (2019). From ecological macroeconomics to a theory of endogenous money for a finite planet. Ecological Economics, 162, 108-120.

Weitzman, M. L. (2009). On modeling and interpreting the economics of catastrophic climate change. The Review of Economics and Statistics, 91(1), 1-19.

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MERCI!

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