Climate risk to the financial system

I wrote a piece for Project Syndicate, here,  on climate financial risk.  (This resulted from a presentation on a panel at the NBER summer institute risks of financial institutions meeting, program here. There should be a video version on YouTube but I can't find it. The panel discussion was excellent. You will recognize ideas from my earlier climate finance testimony. I recycle and refine. ) I titled it "an answer in search of a question," but PS didn't like that so we have the "fallacy" title. 

The essay: 

In the United States, the Federal Reserve, the Securities and Exchange Commission, and the Department of the Treasury are gearing up to incorporate climate policy into US financial regulation, following even more audacious steps in Europe. The justification is that “climate risk” poses a danger to the financial system. But that statement is absurd. Financial regulation is being used to smuggle in climate policies that otherwise would be rejected as unpopular or ineffective.  

“Climate” means the probability distribution of the weather – the range of potential weather conditions and events, together with their associated probabilities. “Risk” means the unexpected, not changes that everyone knows are underway. And “systemic financial risk” means the possibility that the entire financial system will melt down, as nearly happened in 2008. It does not mean that someone somewhere might lose money because some asset price falls, though central bankers are swiftly enlarging their purview in that direction. 

In plain language, then, a “climate risk to the financial system” means a sudden, unexpected, large, and widespread change in the probability distribution of the weather, sufficient to cause losses that blow through equity and long-term debt cushions, provoking a system-wide run on short-term debt. This means the five- or at most ten-year horizon over which regulators can begin to assess the risks on financial institutions’ balance sheets. Loans for 2100 have not been made yet.

Such an event lies outside any climate science. Hurricanes, heat waves, droughts, and fires have never come close to causing systemic financial crises, and there is no scientifically validated possibility that their frequency and severity will change so drastically to alter this fact in the next ten years. Our modern, diversified, industrialized, service-oriented economy is not that affected by weather – even by headline-making events. Businesses and people are still moving from the cold Rust Belt to hot and hurricane-prone Texas and Florida. 

If regulators are worried even-handedly about out-of-the-box risks that endanger the financial system, the list should include wars, pandemics, cyberattacks, sovereign-debt crises, political meltdowns, and even asteroid strikes. All but the latter are more likely than climate risk. And if we are worried about flood and fire costs, perhaps we should stop subsidizing building and rebuilding in flood and fire-prone areas. 

Climate regulatory risk is slightly more plausible. Environmental regulators could turn out to be so incompetent that they damage the economy to the point of creating a systemic run. But that scenario seems far-fetched even to me. Again though, if the question is regulatory risk, then even-handed regulators should demand a wider recognition of all political and regulatory risks. Between the Biden administration’s novel interpretations of antitrust law, the previous administration’s trade policies, and the pervasive political desire to “break up big tech,” there is no shortage of regulatory danger.

To be sure, it is not impossible that some terrible climate-related event in the next ten years can provoke a systemic run, though nothing in current science or economics describes such an event. But if that is the fear, the only logical way to protect the financial system is by dramatically raising the amount of equity capital, which protects the financial system against any kind of risk. Risk measurement and technocratic regulation of climate investments, by definition, cannot protect against unknown unknowns or un-modeled “tipping points.” 

What about “transition risks” and “stranded assets?” Won’t oil and coal companies lose value in the shift to low-carbon energy? Indeed they will. But everyone already knows that. Oil and gas companies will lose more value only if the transition comes faster than expected. And legacy fossil-fuel assets are not funded by short-term debt, as mortgages were in 2008, so losses by their stockholders and bondholders do not imperil the financial system. “Financial stability” does not mean that no investor ever loses money.

Moreover, fossil fuels have always been risky. Oil prices turned negative last year, with no broader financial consequences. Coal and its stockholders have already been hammered by climate regulation, with not a hint of financial crisis.  

More broadly, in the history of technological transitions, financial problems have never come from declining industries. The stock-market crash of 2000 was not caused by losses in the typewriter, film, telegraph, and slide-rule industries. It was the slightly-ahead-of-their-time tech companies that went bust. Similarly, the stock-market crash of 1929 was not caused by plummeting demand for horse-drawn carriages. It was the new radio, movie, automobile, and electric appliance industries that collapsed.

If one is worried about the financial risks associated with the energy transition, new astronomically-valued darlings such as Tesla are the danger. The biggest financial danger is a green bubble, fueled as previous booms by government subsidies and central-bank encouragement. Today’s high-fliers are vulnerable to changing political whims and new and better technologies. If regulatory credits dry up or if hydrogen fuel cells displace batteries, Tesla is in trouble. Yet our regulators wish only to encourage investors to pile on. 

Climate financial regulation is an answer in search of a question. The point is to impose a specific set of policies that cannot pass via regular democratic lawmaking or regular environmental rulemaking, which requires at least a pretense of cost-benefit analysis.

These policies include defunding fossil fuels before replacements are in place, and subsidizing battery-powered electric cars, trains, windmills, and photovoltaics – but not nuclear, carbon capture, hydrogen, natural gas, geoengineering, or other promising technologies. But, because financial regulators are not allowed to decide where investment should go and what should be starved of funds, “climate risk to the financial system” is dreamed up and repeated until people believe it, in order to shoehorn these climate policies into financial regulators’ limited legal mandates.

Climate change and financial stability are pressing problems. They require coherent, intelligent, scientifically valid policy responses, and promptly. But climate financial regulation will not help the climate, will further politicize central banks, and will destroy their precious independence, while forcing financial companies to devise absurdly fictitious climate-risk assessments will ruin financial regulation. The next crisis will come from some other source. And our climate-obsessed regulators will once again fail utterly to anticipate it – just as a decade’s worth of stress testers never considered the possibility of a pandemic.

*****

In retrospect I should have emphasized one point more strongly. Suppose you do believe that there is a "climate risk" to the financial system, a "tipping point" that can happen in the next 5-10 years. Suppose you believe that all our forest fires and floods are the result only of climate change, and might engulf the economy in the next decades.  If so, none of the currently advocated policies will do anything about it, especially those implemented by financial regulation.  The best the most aggressive climate policies hope to do is to limit the further increase in temperature by 2100.  Cutting fossil fuels out of debt markets, printing money to buy windmill and electric car bonds, a full on ESG effort in money management ... none of this will lower carbon dioxide to pre-industrial levels in the next 10 years. None of this will stop wildfires and floods in your great-grandchildren's lifetimes. 

It follows, that if financial regulators accept even the most climate-alarmist position, and for the goal of protecting the financial system, the policy must be one of rapid adaptation. Spend billions to clear the brush that burns, to build dikes, and certainly not to rebuild crumbling condos on the sea shore.  The mantra (I listen to NPR) that each disaster is the result of climate change does not mean that any currently envisioned climate policy is the best, or even vaguely effective, way to combat the chance of such disasters in our lifetimes. Or those of our great-grandchildren. 

That simple fact does not mean we should ignore the climate, but it does mean that if you truly believe these scenarios, an immense adaptation effort must be undertaken right now. If you don't follow to that conclusion, perhaps you don't really believe that there is a climate financial risk, and this is just a subterfuge to pass policies actually aimed at year 2100 temperatures and having nothing to do with climate risks, by radically un-democratic means. Which is my point. 

Yellen on climate

There was an error in a post with this title, so I have taken it down. Since nothing is ever fully erased on the web, this note states that the earlier one had an error. 

Rossi-Hansberg on the effects of a carbon tax

I was inspired to think again about climate economics from Esteban Rossi-Habnsberg's excellent presentation at the  Hoover Economic Policy Working Group. Link here in case the above embed does not work. Paper here, (with Jose Luis Cruz Alvarez), slides here. Previous introductory post here. 

There is a lot in this paper and presentation, and I'm going to try to stick to one topic per post. 

Like most economists, my knee jerk reaction to climate change is "carbon tax." In particular, a carbon tax instead of extensive regulation. Given that we're going to have a climate policy that discourages carbon emissions, a uniform price on carbon emissions is the only sensible and effective way to do it. (Whether tax, tradeable rights, or other mechanism doesn't matter for this purpose.) I would add remove barriers to alternatives, such as nuclear power, and a healthy expenditure on basic science of alternatives. 

With that in mind, I was stunned by these graphs:

Carbon taxes do not stop climate change. They just postpone it. They do postpone it substantially. In the bottom graph, we get 4 degrees rather than 6 by 2100. But still, we're at the same place by 2300. 

How much does climate change actually affect GDP? Part I: An illogical question.

How much does climate change* actually affect GDP? How much will currently-envisioned climate policies reduce that damage, and thereby raise GDP? As we prepare to spend trillions and trillions of dollars on climate change, this certainly seems like the important question that economists should have good answers for. I'm looking in to what anyone actually knows about these questions. The answer is surprisingly little, and it seems a ripe area for research. This post begins a series.  

I haven't gotten deep in this issue before, because of a set of overriding facts and logical problems. I don't see how these will change, but the question frames my investigation. 

An illogical question

The economic effects of climate change are dwarfed by growth. 

Take even worst-case estimates that climate change will lower GDP by 5-10% in the year 2100. Compared to growth, that's couch change. At our current tragically low 2% per year, without even compounding (or in logs), GDP in 2100 will be 160% greater than now. Climate change will make 2100 be as terrible as... 2095 would otherwise be.  If we could boost growth to 3% per year, GDP in 2100 will be 240% greater than now, an extra 80 percentage points.  8% in 80 years is one tenth of a percent per year growth. That's tiny.  

In the 72 years since 1947, US GDP per capita grew from $14,000 to $57,000 in real terms, a 400% increase, and real GDP itself grew from $2,027 T to $19,086 T, a 900% increase. Just returning to the 1945-2000 growth rate would dwarf the effects of climate change and the GDP-increasing effects of climate policy. 

Comparing the US and Europe, Europe is about 40% below the US in GDP Per Capita, and the the US is about 60% above Europe. So Europe's institutions do on the order of 5-10 times more damage to GDP than climate change.    

Residential zoning alone costs something like 10-20% of GDP, by keeping people away from high productivity jobs. Abandoning migration restrictions could as much as double world GDP (also here). 

It is often said that climate change will hit different countries differentially, and poor countries more, so it's an "equity" issue as much as a rich-country GDP issue. Yet just since 1990, China's GDP Per Capita has grown 1,100%, from $729 to $8405 (World bank). As the world got hotter. 1,100% is a lot more than 10%. We'll look at poor country GDP climate effects, but from what I've seen so far, reducing carbon doesn't get 1,100% gains. 

Lessons learned? Review of a great review.

After great events, will the US government and political system learn from mistakes? Or will we raise the bridges and enshrine whatever was done last time as holy writ, to be repeated again? Reputations of people in power push for the latter. But learning from mistakes is the only way to get ahead. 

Bailouts and stimulus from 2008 seem to have followed the latter possibility. Will the lesson from covid look skeptically on the disastrous performance of CDC and FDA, evaluate whether lockdowns did good commensurate with cost, question the need to spread trillions of newly printed money around, measure the  effectiveness of masks that have now become political symbols? Or will this simply be enshrined as the playbook? Do we twist every event to push our partisan narratives, facts be damned? A blame-Trump-for-everything camp offers some hope, but they're not clear what they would do differently as most of the world's response was the same or less effective than our own. 

This big question frames a must-read Alex Tabarrok Marginal Revolution review of Andy Slavitt’s Preventable. The review doesn't just destroy an otherwise forgettable book, but it really raises these larger questions whether we are so politically polarized that we can no longer learn from mistakes. 

In contemporary discussion, people can just say things that are blatantly untrue, and it all washes over us. 

The standard narrative ... leads Slavitt to make blanket assertions—the kind that everyone of a certain type knows to be true–but in fact are false. He writes, for example:

In comparison to most of these other countries, the American public was impatient, untrusting, and unaccustomed to sacrificing individual rights for the public good. (p. 65)

Data from the Oxford Coronavirus Government Response Tracker (OxCGRT) show that the US “sacrifice” as measured by the stringency of the COVID policy response–school closures; workplace closures; restrictions on public gatherings; restrictions on internal movements; mask requirements; testing requirements and so forth–was well within the European and Canadian average.

The pandemic and the lockdowns split Americans from their friends and families. Birthdays, anniversaries, even funerals were relegated to Zoom. Jobs and businesses were lost in the millions. Children couldn’t see their friends or even play in the park. Churches and bars were shuttered. Music was silenced. Americans sacrificed plenty.

... Some of Slavitt’s assertions are absurd.

The U.S. response to the pandemic differed from the response in other parts of the world largely in the degree to which the government was reluctant to interfere with our system of laissez-faire capitalism…

Laissez-faire capitalism??! Political hyperbole paired with lazy writing. It would be laughable except for the fact that such hyperbole biases our thinking. 

I think the problem is deeper. It's not that this is "hyperbole." It's that this is the sort of mushy sentiment that one can pass around at Washington cocktail parties as easily as write on the front pages of all major media these days, and everyone says yes, sure, without batting an eyelash. It's not hyperbole, it is the unquestioned narrative, it's an inshallah people can add to any statement without question. That's the true danger.