The recent stress in financial markets caused by the COVID-19 pandemic is an important reminder that shocks do not just come from sources that are endogenous to the financial system, as in the case of the financial crisis of 2008. They are also caused by exogenous sources. A number of central banks, financial regulators, and other public sector entities are recognizing that climate change may pose just such an exogenous risk to the financial system.
My recent working paper, ‘Confronting the ‘Climate Lehman Moment’: the Case for Macroprudential Climate Regulation’, seeks to build on their work by examining the financial risks of climate change, considering those risks through the framework that financial regulators in the United States have developed for evaluating systemically risky activities, and then proposing potential policy options that regulators could adopt to ensure that financial institutions internalize the systemic risks that they create by financing carbon-intensive industries.
While policymakers outside of the United States are farther along in their analyses of climate risks than we are in the US, my paper seeks to contribute to the dialogue in two ways that may be of interest to an international audience. First, it offers more detail about how climate risks could become financial risks that are systemic in nature, based upon our understanding of how such risk materializes. Second, it offers additional potential policy responses that have not yet been proposed.
From Climate Risk to Systemic Risk
There are two types of financial risks created by climate change, the risks of physical damage caused by climate change and the risks of losses in certain asset classes from the transition away from a carbon-based economy. These risks can then manifest in financial transactions in two ways: by increasing the risk of a credit default or by impairing the operation of financial markets. Those risks can then spread throughout the financial system through either troubled counterparties or asset classes.
Climate-related risks have the potential to compound because climate change-causing activities create and exacerbate multiple types of risk. The more that financial institutions invest in fossil fuels, the more climate change they cause, leading to more potential and actual damage to their investment assets. At the same time, the longer that financial institutions continue to invest in carbon-intensive assets makes the transition to a clean energy economy likely to be costlier when it actually happens.
To consider some ways that this might play out, contemplate the implications of a climate change-driven corporate bankruptcy—for example, a large utility as in the case of Pacific Gas & Electric or oil and gas companies affected by the recent sudden and precipitous drop in oil prices—causing a cascade of loan and/or bond payment defaults that spread throughout the financial system. Or the implications for assets on the balance sheets of regional or national banks if a major property and casualty insurer elected not to roll over existing, or insure new, property policies for real estate in a major mortgage coastal market that is exposed to outsized risk of hurricanes or flooding. Or the potential for a fire sale of fossil fuel company equities by trillion-dollar asset managers if a major country’s legislature passed a prohibition against new oil and natural gas exploration and extraction.
The potential for a climate-driven event has been given many different names, from the ‘climate Minsky moment’ to a ‘green swan’ event. In an attempt to appeal to the imaginations of US policymakers, I refer to it as the ‘climate Lehman moment’: an event akin to the bankruptcy of the investment bank Lehman Brothers that in many ways triggered the worst of the financial panic of 2008, but this time driven by climate change.
In all of these hypothetical scenarios, the risks derive from financial institutions’ investments in the industries and activities that drive climate change: primarily fossil fuels, deforestation-related commodities, and the 100 largest corporate emitters. These financing activities produce two sets of potent negative externalities, exposing the public to significant potential costs. First, there is the carbon pollution that is pumped into the air that falls on governments to abate in some fashion. Second, there are the financial risks being created by climate change that threaten to grow into distress that spreads from the financial system to the broader economy, resulting in public bailouts.
Internalizing the Financial Costs of Climate Risk
The financial sector’s ability to support the broader economy in the event of climate-driven losses depends on the degree to which the financial system itself is either vulnerable to, or resilient in the face of, the climate crisis. Ex ante regulation is needed both to keep the markets functioning, as well as to avoid public authorities becoming the ‘climate rescuers of last resort’. Threats to financial stability require a macroprudential framework for regulation, an approach that attempts to anticipate emerging risks before they come to fruition, account for interlinkages across various sectors of the financial system, and regulate system-wide risks in a comprehensive manner regardless of entity or market-type.
The major proposed innovation in climate-related macroprudential regulation is ‘stress testing’—the measurement of potential risks in hypothetical climate-induced market scenarios. This is a complicated undertaking, but an important one for measuring and understanding a range of quantitative issues related to climate risk, from institutions’ carbon footprints to the second-order effects of climate-related stresses on a company’s balance sheet.
A holistic approach to macroprudential climate regulation would not just incorporate these new risk measurement and management tools; it would use such measures to craft substantive, prudential rules for climate change-driving investments. Such rules could include heightened capital and margin requirements for lending, securities, derivatives, and commodities transactions that contribute to climate change, and therefore increase climate-related financial risks. These regulations could be applied at the individual transaction level, or at the aggregate portfolio level. Ideally, such rules would be designed with the aim of forcing financial institutions to internalize the costs of the dual externalities created by those activities.
Depending upon the impact of these mechanisms, on both financial risks as well as carbon emissions, regulators might also consider more robust interventions. For example, they could impose portfolio limits on financial institutions, based upon aggregate financing or carbon emissions.
The point here is that regulators have a range of tools at their disposal. My central argument is that, to meet the urgency of, and uncertainty inherent in, climate change will require policymakers to move beyond mere quantification and disclosure.
Graham Steele is the Director of the Corporations & Society Initiative at Stanford Graduate School of Business.