Attention to the green swans

Enrique Flores placeholder image

Statistician Nassim Nicholas Taleb coined the term

black swan

to describe unlikely and difficult-to-predict events that can have a huge impact on the economy.

The authors of a recent report have now introduced the term

green swans

: events caused by climate change and biodiversity loss

into the taxonomy of finance

.

The appearance of green swans is probably more predictable than that of black swans, as climate change makes them inevitable.

But there are no historical comparisons to help us understand how climate and ecological risks such as cyclones, wildfires, droughts, and floods can affect the banking system, the insurance industry, or other economic activities.

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As economic activity shifts from fossil fuels to clean energy sources, some activities will disappear, others will emerge, and the value of "fixed assets" will plummet. Although this process is necessary, it must be managed in such a way that it does not create instability in the financial system.

Due to their financial stability mandate, central banks, supervisors, and regulatory authorities have a central role to play in the green transition. The recent Green Swans Conference organized by the Bank for International Settlements, the Bank of France, the International Monetary Fund and the NGFS (Network of Central Banks and Supervisors to Green the Financial System) points to a growing recognition of this fact, although the Mobilization is still too slow and too timid in some geographic areas.

With a view to anticipating the effects of climate risk, the Bank of France was the first central bank to introduce a comprehensive climate stress test for banks and insurance companies.

By analyzing three 30-year climate scenarios designed by the NGFS (an orderly transition based on a low-carbon strategy; a disorderly and late transition, and a scenario where everything remains the same), the test attempted to assess the Exposure of banking and insurance industry portfolios to both physical and transition risks.

This exercise showed that the current exposure of the French system is only moderate (based on the assumptions used).

Most importantly, the climate stress test demonstrated what it will take to improve our understanding of climate risk.

There is much more work to be done. For example, we still lack databases detailing geographic conditions in global value chains. This information is essential for assessing physical risks to production and would also be useful for monitoring social and environmental governance issues more broadly.

The increased frequency and severity of weather-related disasters will gradually be reflected in insurance coverage and costs, affecting the profitability and default rates of loan portfolios in the banking sector. At the same time, bankers and asset managers will adjust their portfolios accordingly. And if the price of carbon continues to rise, as it should, they will move away from carbon-intensive sectors, increasing their exposure to other risk factors.

These time-varying behaviors (and their side effects) will be relevant to financial stability, but they are difficult to model. Still, a few essential policies would greatly help regulators and investors manage change. First, those embarking on the green transition will need a compass: there should be an absolutely predictable increase in the price of carbon over as wide an economic area as possible. The European Union could be on the right track here with its Emissions Trading System (ETS), where the price of carbon has risen from 25 euros ($ 30) per tonne in January 2020 to 50 euros per ton today. But progress is still limited, because the ETS covers only about 40% of EU emissions.

As a recent G-30 report shows, credible commitments are needed to provide a predictably rising carbon price so investors, regulators and monetary authorities can adjust their forward-looking strategies. If these commitments do not exist, we will not be able to promote public and private investment in the structural adjustments necessary to reduce the costs of the broader transition.

To achieve this, independent carbon councils can manage carbon price inflation in a similar way to how central banks manage inflation that affects product prices. These institutions should have a mandate to chart a carbon price inflation path in line with the 2050 net zero targets of their respective governments. These policies must be accompanied by compensation for those most affected by a drop in purchasing power due, for example, to an increase in fuel prices.

Capital requirements for financial institutions could be associated with their exposure to a rising carbon price, which would change their calculated probability of defaults and losses on their portfolio. Supervisors will also need to ensure that financial institutions establish effective governance systems to deal with climate risk. Unlike shadow banking, whose growth reflected an ability to avoid stricter banking regulations, we should strive to closely track “shadow issuers”. The US Environmental Protection Agency recently revealed that five of the top 10 US methane emitters are little-known oil and gas producers, backed by little-known investment firms.

Presumably private equity firms will attempt to acquire risky oil and gas properties, develop them, and sell them at a profit. But we cannot tolerate “under the radar” investors buying high carbon assets at settlement prices and then trading them in lax jurisdictions. Preventing this will require a high global carbon price floor, border tax adjustments for carbon, or both. The cost of capital for these investments must become prohibitively high, even if this means adjusting the regulatory perimeter.

A final key component of climate policy is mandatory CO₂ emissions disclosures and a framework to harmonize these disclosures globally to apply universal minimum standards.

This idea is already gaining momentum and may become more concrete after the United Nations climate summit (COP26) in November.

Transparency is crucial for all market participants.

It is incumbent upon the institutions in charge of financial stability to ensure that green swans do not turn black.

Hélène Rey

is Professor of Economics at the London Business School and a member of the High Council for Financial Stability.