MONDAY’S STUDY: The Threat Of The Green Swan
The Green Swan: Central banking and financial stability in the age of climate change
Patrick Bolton, Morgan Despres, Luiz Awazu Pereira Da Silva, Frédéric Samama, And Romain Svartzman, January 2020 (Bank for International Settlements/Banque de France)
Climate change poses new challenges to central banks, regulators and supervisors. This book reviews ways of addressing these new risks within central banks’ financial stability mandate. However, integrating climate-related risk analysis into financial stability monitoring is particularly challenging because of the radical uncertainty associated with a physical, social and economic phenomenon that is constantly changing and involves complex dynamics and chain reactions. Traditional backward-looking risk assessments and existing climate-economic models cannot anticipate accurately enough the form that climate-related risks will take. These include what we call “green swan” risks: potentially extremely financially disruptive events that could be behind the next systemic financial crisis. Central banks have a role to play in avoiding such an outcome, including by seeking to improve their understanding of climaterelated risks through the development of forward-looking scenario-based analysis.
But central banks alone cannot mitigate climate change. This complex collective action problem requires coordinating actions among many players including governments, the private sector, civil society and the international community. Central banks can therefore have an additional role to play in helping coordinate the measures to fight climate change. Those include climate mitigation policies such as carbon pricing, the integration of sustainability into financial practices and accounting frameworks, the search for appropriate policy mixes, and the development of new financial mechanisms at the international level. All these actions will be complex to coordinate and could have significant redistributive consequences that should be adequately handled, yet they are essential to preserve long-term financial (and price) stability in the age of climate change.
This book reviews some of the main challenges that climate change poses to central banks, regulators and supervisors, and potential ways of addressing them. It begins with the growing realisation that climate change is a source of financial (and price) instability: it is likely to generate physical risks related to climate damages, and transition risks related to potentially disordered mitigation strategies. Climate change therefore falls under the remit of central banks, regulators and supervisors, who are responsible for monitoring and maintaining financial stability. Their desire to enhance the role of the financial system to manage risks and to mobilise capital for green and low-carbon investments in the broader context of environmentally sustainable development prompted them to create the Central Banks and Supervisors Network for Greening the Financial System (NGFS).
However, integrating climate-related risk analysis into financial stability monitoring and prudential supervision is particularly challenging because of the distinctive features of climate change impacts and mitigation strategies. These comprise physical and transition risks that interact with complex, far-reaching, nonlinear, chain reaction effects. Exceeding climate tipping points could lead to catastrophic and irreversible impacts that would make quantifying financial damages impossible. Avoiding this requires immediate and ambitious action towards a structural transformation of our economies, involving technological innovations that can be scaled but also major changes in regulations and social norms.
Climate change could therefore lead to “green swan” events (see Box A) and be the cause of the next systemic financial crisis. Climate-related physical and transition risks involve interacting, nonlinear and fundamentally unpredictable environmental, social, economic and geopolitical dynamics that are irreversibly transformed by the growing concentration of greenhouse gases in the atmosphere.
In this context of deep uncertainty, traditional backward-looking risk assessment models that merely extrapolate historical trends prevent full appreciation of the future systemic risk posed by climate change. An “epistemological break” (Bachelard (1938)) is beginning to take place in the financial community, with the development of forward-looking approaches grounded in scenario-based analyses. These new approaches have already begun to be included in the financial industry’s risk framework agenda, and reflections on climate-related prudential regulation are also taking place in several jurisdictions.
While these developments are critical and should be pursued, this book presents two additional messages. First, scenario-based analysis is only a partial solution to apprehend the risks posed by climate change for financial stability. The deep uncertainties involved and the necessary structural transformation of our global socioeconomic system are such that no single model or scenario can provide a full picture of the potential macroeconomic, sectoral and firm-level impacts caused by climate change. Even more fundamentally, climate-related risks will remain largely unhedgeable as long as system-wide action is not undertaken.
Second, it follows from these limitations that central banks may inevitably be led into uncharted waters in the age of climate change. On the one hand, if they sit still and wait for other government agencies to jump into action, they could be exposed to the real risk of not being able to deliver on their mandates of financial and price stability. Green swan events may force central banks to intervene as “climate rescuers of last resort” and buy large sets of devalued assets, to save the financial system once more. However, the biophysical foundations of such a crisis and its potentially irreversible impacts would quickly show the limits of this “wait and see” strategy. On the other hand, central banks cannot (and should not) simply replace governments and private actors to make up for their insufficient action, despite growing social pressures to do so. Their goodwill could even create some moral hazard. In short, central banks, regulators and supervisors can only do so much (and many of them are already taking action within their mandates), and their action can only be seen as enhancing other climate change mitigation policies.
To overcome this deadlock, a second epistemological break is needed: central banks must also be more proactive in calling for broader and coordinated change, in order to continue fulfilling their own mandates of financial and price stability over longer time horizons than those traditionally considered. We believe that they can best contribute to this task in a role that we dub the five Cs: contribute to coordination to combat climate change. This coordinating role would require thinking concomitantly within three paradigmatic approaches to climate change and financial stability: the risk, time horizon and system resilience approaches (see Box B).
Contributing to this coordinating role is not incompatible with central banks, regulators and supervisors doing their own part within their current mandates. They can promote the integration of climate-related risks into prudential regulation and financial stability monitoring, including by relying on new modelling approaches and analytical tools that can better account for the uncertainty and complexity at stake. In addition, central banks can promote a longer-term view to help break the “tragedy of the horizon”, by integrating sustainability criteria into their own portfolios and by exploring their integration in the conduct of financial stability policies, when deemed compatible with existing mandates.
But more importantly, central banks need to coordinate their own actions with a broad set of measures to be implemented by other players (ie governments, the private sector, civil society and the international community). This coordination task is urgent since climate-related risks continue to build up and negative outcomes could become irreversible. There is an array of actions to be consistently implemented. The most obvious ones are the need for carbon pricing and for systematic disclosure of climate-related risks by the private sector.
Taking a transdisciplinary approach, this book calls for additional actions that no doubt will be difficult to take, yet will also be essential to preserve long-term financial (and price) stability in the age of climate change. These include: exploring new policy mixes (fiscal-monetary-prudential) that can better address the climate imperatives ahead and that should ultimately lead to societal debates regarding their desirability; considering climate stability as a global public good to be supported through measures and reforms in the international monetary and financial system; and integrating sustainability into accounting frameworks at the corporate and national level.
Moreover, climate change has important distributional effects both between and within countries. Risks and adaptation costs fall disproportionately on poor countries and low-income households in rich countries. Without a clear indication of how the costs and benefits of climate change mitigation strategies will be distributed fairly and with compensatory transfers, sociopolitical backlashes will increase. Thus, the needed broad social acceptance for combating climate change depends on studying, understanding and addressing its distributional consequences.
Financial and climate stability could be considered as two interconnected public goods, and this consideration can be extend to other human-caused environmental degradation such as the loss of biodiversity. These, in turn, require other deep transformations in the governance of our complex adaptive socioeconomic and financial systems. In the light of these immense challenges, a central contribution of central banks is to adequately frame the debate and thereby help promote the mobilisation of all capabilities to combat climate change.
From Black to Green Swans
The “green swan” concept used in this book finds its inspiration in the now famous concept of the “black swan” developed by Nassim Nicholas Taleb (2007). Black swan events have three characteristics: (i) they are unexpected and rare, thereby lying outside the realm of regular expectations; (ii) their impacts are wide-ranging or extreme; (iii) they can only be explained after the fact. Black swan events can take many shapes, from a terrorist attack to a disruptive technology or a natural catastrophe. These events typically fit fat tailed probability distributions, ie they exhibit a large skewness relative to that of normal distribution (but also relative to exponential distribution). As such, they cannot be predicted by relying on backward-looking probabilistic approaches assuming normal distributions (eg value-at-risk models).
The existence of black swans calls for alternative epistemologies of risk, grounded in the acknowledgment of uncertainty. For instance, relying on mathematician Benoît Mandelbrot (1924–2010), Taleb considers that fractals (mathematically precise patterns that can be found in complex systems, where small variations in exponent can cause large deviation) can provide more relevant statistical attributes of financial markets than both traditional rational expectations models and the standard framework of Gaussian-centred distributions (Taleb (2010)). The use of counterfactual reasoning is another avenue that can help hedge, at least partially, against black swan events. Counterfactuals are thoughts about alternatives to past events, “thoughts of what might have been” (Epstude and Roese (2008)). Such an epistemological position can provide some form of hedging against extreme risks (turning black swans into “grey” ones) but not make them disappear. From a systems perspective, fat tails in financial markets suggest a need for regulation in their operations (Bryan et al (2017), p 53).
Green swans, or “climate black swans”, present many features of typical black swans. Climate-related risks typically fit fat-tailed distributions: both physical and transition risks are characterised by deep uncertainty and nonlinearity, their chances of occurrence are not reflected in past data, and the possibility of extreme values cannot be ruled out (Weitzman (2009, 2011)). In this context, traditional approaches to risk management consisting in extrapolating historical data and on assumptions of normal distributions are largely irrelevant to assess future climaterelated risks. That is, assessing climate-related risks requires an “epistemological break” (Bachelard (1938)) with regard to risk management, as discussed in this book.
However, green swans are different from black swans in three regards. First, although the impacts of climate change are highly uncertain, “there is a high degree of certainty that some combination of physical and transition risks will materialize in the future” (NGFS (2019a), p 4). That is, there is certainty about the need for ambitious actions despite prevailing uncertainty regarding the timing and nature of impacts of climate change. Second, climate catastrophes are even more serious than most systemic financial crises: they could pose an existential threat to humanity, as increasingly emphasized by climate scientists (eg Ripple et al (2019)). Third, the complexity related to climate change is of a higher order than for black swans: the complex chain reactions and cascade effects associated with both physical and transition risks could generate fundamentally unpredictable environmental, geopolitical, social and economic dynamics, as explored in Chapter 3…
Conclusion – Central Banking And System Resilience
Climate change poses an unprecedented challenge to the governance of socioeconomic systems. The potential economic implications of physical and transition risks related to climate change have been debated for decades (not without methodological challenges), yet the financial implications of climate change have been largely ignored.
Over the past few years, central banks, regulators and supervisors have increasingly recognised that climate change is a source of major systemic financial risks. In the absence of well coordinated and ambitious climate policies, there has been a growing awareness of the materiality of physical and transition risks that would affect the stability of the financial sector. Pursuing the current trends could leave central banks in the position of “climate rescuers of last resort”, which would become untenable given that there is little that monetary and financial flows can do against the irreversible impacts of climate change. In other words, a new global financial crisis triggered by climate change would render central banks and financial supervisors powerless.
Integrating climate-related risks into prudential regulation and identifying and measuring these risks is not an easy task. Traditional risk management relying on the extrapolation of historical data, despite its relevance for other questions related to financial stability, cannot be used to identify and manage climate-related risks given the deep uncertainty involved. Indeed, climate-related risks present many distinctive features. Physical risks are subject to nonlinearity and uncertainty not only because of climate patterns, but also because of socioeconomic patterns that are triggered by climate ones. Transition risks require including intertwined complex collective action problems and addressing well known political economy considerations at the global and local levels. Transdisciplinary approaches are needed to capture the multiple dimensions (eg geopolitical, cultural, technological and regulatory ones) that should be mobilised to guarantee the transition to a low-carbon socio-technical system.
These features call for an epistemological break (Bachelard (1938)) with regard to financial regulation, ie a redefinition of the problem at stake when it comes to identifying and addressing climaterelated risks. Some of this break is already taking place, as financial institutions and supervisors increasingly rely on scenario-based analysis and forward-looking approaches rather than probabilistic ones to assess climate-related risks. This is perhaps compounding a new awareness that is beginning to produce a repricing of climate-related risks. That, in turn, can contribute to tilting preferences towards lower-carbon projects and might therefore act, to some extent, as a “shadow price” for carbon emissions.
While welcoming this development and strongly supporting the need to fill methodological, taxonomy and data gaps, the essential step of identifying and measuring climate-related risks presents significant methodological challenges related to:
(i) The choice of a scenario regarding how technologies, policies, behaviours, geopolitical dynamics, macroeconomic variables and climate patterns will interact in the future, especially given the limitations of climate-economic models. (ii)
The translation of such scenarios into granular corporate metrics in an evolving environment where all firms and value chains will be affected in unpredictable ways.
(iii) The task of matching the identification of a climate-related risk with the adequate mitigation action.
In short, the development and improvement of forward-looking risk assessment and climaterelated regulation will be essential, but they will not suffice to preserve financial stability in the age of climate change: the deep uncertainty involved and the need for structural transformation of the global socioeconomic system mean that no single model or scenario can provide sufficient information to private and public decision-makers. A corollary is that the integration of climate-related risks into prudential regulation and (to the extent possible) into monetary policy would not suffice to trigger a shift capable of hedging the whole system again against green swan events.
Because of these limitations, climate change risk management policy could drag central banks into uncharted waters: on the one hand, they cannot simply sit still until other branches of government jump into action; on the other, the precedent of unconventional monetary policies of the past decade (following the 2007–08 Great Financial Crisis), may put strong sociopolitical pressure on central banks to take on new roles like addressing climate change. Such calls are excessive and unfair to the extent that the instruments that central banks and supervisors have at their disposal cannot substitute for the many areas of interventions that are necessary to achieve a global low-carbon transition. But these calls might be voiced regardless, precisely because of the procrastination that has been the dominant modus operandi of many governments for quite a while. The prime responsibility for ensuring a successful low-carbon transition rests with other branches of government, and insufficient action on their part puts central banks at risk of no longer being able to deliver on their mandates of financial (and price) stability.
To address this latter problem, a second epistemological break is needed. There is also a role for central banks to be more proactive in calling for broader change. In this spirit, and grounded in the transdisciplinary approach that is required to address climate change, this book calls for actions beyond central banks that are essential to guarantee financial (and price) stability.
Central banks can also play a role as advocates of broader socioeconomic changes without which their current policies and the maintenance of financial stability will have limited chances of success. Towards this objective, we have identified four (non-exhaustive) propositions beyond carbon pricing:
(i) Central banks can help proactively promote long-termism by supporting the values or ideals of sustainable finance.
(ii) Central banks can call for an increased role for fiscal policy in support of the ecological transition, especially at the zero lower bound.
(iii) Central banks can increase cooperation on ecological issues among international monetary and financial authorities.
(iv) Central banks can support initiatives promoting greater integration of climate and sustainability dimensions within corporate and national accounting frameworks.
Financial and climate stability are two increasingly interdependent public goods. But, as we enter the Anthropocene (Annex 4), long-term sustainability extends to other human-caused environmental degradations such as biodiversity loss, which could pose new types of financial risks (Schellekens and van Toor (2019)). Alas, it may be even more difficult to address these ecological challenges. For instance, preserving biodiversity (often ranked second in terms of environmental challenges) is a much more complex problem from a financial stability perspective, among other things because it relies on multiple local indicators despite being a global problem (Chenet (2019b)).
The potential ramifications of these environmental risks for financial stability are far beyond the scope of this book. Yet, addressing them could become critical for central banks, regulators and supervisors insofar as the stability of the Earth system is a prerequisite for financial and price stability. In particular, the development of systems analysis has been identified as a promising area of research that should inform economic and financial policies in the search for fair and resilient complex adaptive systems in the 21st century (Schoon and van der Leeuw (2015), OECD (2019a)). Future research based on institutional, evolutionary and political economy approaches may also prove fundamental to address financial stability in the age of climate- and environment-related risks.
Faced with these daunting challenges, a key contribution of central banks and supervisors may simply be to adequately frame the debate. In particular, they can play this role by: (i) providing a scientifically uncompromising picture of the risks ahead, assuming a limited substitutability between natural capital and other forms of capital; (ii) calling for bolder actions from public and private sectors aimed at preserving the resilience of Earth’s complex socio-ecological systems; and (iii) contributing, to the extent possible and within the remit of the evolving mandates provided by society, to managing these risks.