Wednesday, July 21, 2021

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. 


  1. Excellent analysis.

    For more about the legal issues raised by climate and other "ESG" disclosure mandates, here's a link to a new article by me and Paul G. Mahoney in the Columbia Business Law Review:

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  3. Playing devil’s advocate to a minor point. Jevon’s 1865 “The Coal Question” argued along malthusian lines of the precipitous collapse of energy growth which would grow exponentially until it couldn’t. Britain’s financial instability and the wars in the 19teens and early ‘20s could look like being related to their peaking of coal production around the same time. Wars are very often a result of natural resources.

  4. I largely agree, yet my estimation of John Cochrane has been diminished.

    Who can stand to listen to NPR anymore?

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    2. Lol. Know thy enemy I guess...

    3. I also, as John Cochrane, listen to NPR because most of the interviews and reporting are interesting. NPR is clearly where "my intellectual opponents" feed today. I like to know the news, but it is very funny how "climate change" makes its way into every story somehow. It reminds me of the Muslim "Inshallah" at the end of every sentence about intention or outcomes.

      The children of Gaia invoke her "change" as holy writ on PBS and contemn the mankind "polluters."
      I switch to BBC after the US political gossip bores me and catch up on events in Africa and Asia, plus all the 'football' standings.

  5. I think the whole piece misses completely the point: the era of independent and apolitical central banks is over. I understand the concerns, but economists have lost this battle: I don't think it is realistic to put the genie back in the bottle.

    1. There was never an apolitical central bank. Just like bipartisanship doesn't mean apartisanship.

  6. "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."

    Isn't this exactly what this whole regulatory agenda is about? It is about increasing the amount of capital held by banks with exposures to polluters.
    If you concede this, the I don't get the point of the piece...

    Is it the disclosures that are problematic? And yet this is something that new generations of investors demand: they want climate information because they have a preference for sustainable investment. If this is what they want, why is it such a bad thing to provide markets with the additional information they need to make more efficient choices?

  7. What a spectacularly uninformed and short-sighted article. Allow me a few illustrations:
    You say the "loans for 2100 are not yet written". True. But you seem to fully ignore that the climate related costs of 3100 due to overuse of fossil fuels are being accumulated now. These "debts" properly discounted should be taken into account ... which I don't believe your financial system does.
    You say extreme weather events and drastic changes in the probability distributions for them cannot destabilize the financial system. You seem to totally ignore that extreme weather, mediated by human behaviour, can lead to significant destruction of asset values. One hot summer or flash flood won't but a sequence of those with an increasing trend of intensity in a handful of years may tip that balance quite suddenly.
    Weather directly influences consumer behaviour, from shopping patterns to consumer confidence. If you truly believe your financial system is immune to the kind of disruptions ahead if we continue our present course then you clearly lack an informed imagination.

    A lack of imagination is the mother of all preventable disasters. Ask any aerospace engineer or general.

  8. This post is great and I value all of these posts as a rare source of logic amidst a sea of illogic.

    I would make one point even more strongly. The blog opening says that Climate is the full probability distribution of weather (or something to this effect).

    The definition of climate that is offered by Koonin in Unsettled is different. Climate is the long run TREND in weather. This definition makes the point in your blog even clearer and more stark. Those that assert that climate presents a serious "risk" have it completely backwards and don't even understand the difference between trend and uncertainty.

    Unfortunately, the main premise of your post is correct. Climate is being used as a cudgel by politicians to affect policy changes that would not otherwise be supported on their own merits. As a result, the substance and truth of the matter is largely if not entirely irrelevant.


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  10. An over-active imagination is certainly the progenitor of disasters that wouldn't have happened otherwise. Ask any historian.

  11. "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. "

    At the current time I see no evidence of un-democratic means because there are no workable plans to mitigate climate change. We talk about it, but do nothing about it. Your "un-democratic" argument does not seem to be on the table.

    As far as I am concerned what the climate change discussion is really about is that humans have become the major changers of all ecosystems. Fisheries, coral reefs, climate, etc.

    Until our leaders open their eyes to the overwhelming power of humans on the rest of the environment, disasters will continue.

    Let me ask you what I believe is a pertinent question:

    why are there so many immigrants across the world today?

    1. Very simple...they mostly come from communist or extreme socialist countries, where the "people" are fodder. Add to that, die-hard believers like you of the "gospel" of climate change, and the combination is literally deadly. If the darn climate of this planet didn't change, you would not be here to opine (really, regurgitate) or repeat platitudes. I do remember Al Gore (remember him?). He "factually" stated in 1991 that "In 15 or 20 years, the sea will rise by a foot" (or some absurd number - I would have to go back and research Al Gore - an abhorrent idea in itself). The "impending doom" climate report draft that just came out, said the sea-level has been up 1.1 INCHES in LAST 100 YEARS, and at the same time, quietly took out another 0.5 inches in future projections per year from last year. Back to Al Gore, he made MILLIONS and MILLIONS off of Grubers like you, while penalizing others.

      Also, although it will date me, back when I was a "young" person, I was told that we are going into global cooling. It was better if I lived in a tropical climate or near the equator. I was told that anything north of the North Tip of Texas would be covered in Ice. Go figure.

      Oh, and an economic argument for you, which you may not understand. However, do an experiment. If you own a business (I doubt that you would really be a business owner - you sound like you are someone who would gladly take a handout), tell your employees that they will not have to work, but will get "pay" no matter what, but even a "free" extra stipend, and healthcare, and childcare, and voting rights. There are very few ones who would show up for real work. Many illegal immigrants come here because they FULLY understand the freebies being given. If they dared to ask in their own land, they would end up on a ditch, because there, their effort will be filling their communist dictator or a socialist messiah's coffers.

      Grow up. This ain't disneyland.

  12. It's even better. Even if a billion people around the equator had to die much earlier in the next 50 years than in a scenario with measures that mitigate man-made climate change, then it could well be that this would not pose an existential risk to the financial system. Thank God!

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    1. Presumably as CO2 concentration within the atmosphere rises,
      O2 concentration falls.

      70 Degrees F is approximately 294 Degrees Kelvin.

      Specific heat of CO2 at 294 Deg Kelvin (70 Deg F) = about 0.84 kJ / (kG * Deg K)
      Specific heat of O2 at 294 Deg Kelvin (70 Deg F) = about 0.915 kJ / (kG * Deg K)

      And so CO2 at an average temperature of 70 Degrees F has a lower specific heat than O2. Meaning that as CO2 replaces O2 in the atmosphere, the net specific heat of the atmosphere falls over time (it takes less energy to raise the temperature of the atmosphere by 1 Degree). That relationship swaps at around 450 Degrees Kelvin.

      Specific heat of CO2 at 450 Deg K (350 Deg F) = about 0.978 kJ / (kG * Deg K)
      Specific heat of O2 at 450 Deg K (350 Deg F) = about 0.956 kJ / (kG * Deg K)

      For comparison, surface temperatures on Venus are about 900 Deg F.
      Atmospheric Composition
      Carbon Dioxide - 96.5 %
      Nitrogen - 3.5 %

      Let me know when we start losing nitrogen in our atmosphere.

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    3. How does the chemical composition of the atmosphere change when various gases come out of solution in the worlds oceans and seas as global water temperatures rise?

      What affect does this have on atmospheric pressure at sea level?

      My presumption would be that the greenhouse effect should raise both global temperatures as well as raise atmospheric pressure through the dissolution of gases in ocean and sea water.

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  15. This brought some thoughts to mind:

    "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."

    If that's the case then efforts for CO2 abatement (don't get me started on grandfathering) in all its forms does seem like a waste of time. If the apocalypse is on its way, what can or should we do? Economics itself isn't prophetic.

    However, in the end my position is that Gifts of Nature allow us to survive and thrive - we are all subject to Nature's mechanisms, even if all the financial machinery falls apart. Still have to eat last time I checked unless you're dead.

    We may not be able to shape Nature to our whims as Machiavelli promotes in The Prince, but we can be prepared based on sound analysis and risk assessment. But we can also use tech and resources to shape our world so that the economy delivers benefits that are good. Have to want the right things and ROI is what drives people to take chances. But ROI means nothing if the economy collapses.

    Then what? Start all over.

  16. This isn't quite right:

    • The regulatory focus is currently on correcting the information gap for market participants to allow climate change to be considered in investment decisions - mostly through reporting requirements (e.g. the SEC has just consulted on climate risk reporting)
    • Market participants themselves are frustrated by the lack of information on this. The corporates that they invest in already have to report financially material risks, but struggle to understand how to include climate change. So more than anything, it’s creating an informational framework to identify and report financially material risks to investors relating to climate. It’s not really a new development, TCFD was created 6 years ago (and is supported by all G20 countries).
    • In terms of smuggling in climate policy, I’m not really aware of any more directive financial regulation on climate change? I don’t think any country has banned or is planning to ban e.g. investments in thermal coal? I don’t think any jurisdiction has adjusted capital weights based on climate? Net zero commitments and transition plans are not currently mandatory - or even within supervisory expectations? But the norms of financial institutions themselves are changing fast, and well ahead of the regulators on this, e.g. Assets under management from financial institutions with net zero commitments are currently at around $37 trillion.
    • The transmission channels from climate change to financial stability has been studied quite a bit - e.g. the financial stability board Central banks are increasingly running stress tests of the financial system to operationally identify these risks, so real date from financial systems is coming soon e.g.
    • The main financial stability risk is thought to be regulatory, not physical risk from climate change. Most large economies now have a net zero commitment - in the UK it’s legally binding that we reduce emissions by 78% by 2035. That would entail significant changes to the real economy which are not yet known or able to be predicted by market participants. Rapid stranding of assets, and knock-on implications for financial stability is a risk - but obviously one that would be mitigated against.
    • But this just covers macro-prudential reasons for regulation, there is also micro-prudential, and consumer-facing conduct regulation. The ESG market is growing rapidly. 70% of consumers in the UK want their money to go to good causes. And we know that green-washing is quite wide-spread, claims about environmental impact of financial products are currently unregulated. So there other reasons for financial regulation relating to climate change than financial stability.

    1. "to allow climate change to be considered in investment decisions"

      But what exactly is this risk? For example, if we have a swap agreement with each other, then we know our potential exposure to each other. We can report that. How do we quantify the above risk that you mention? On top of garbage climate models, we are adding further garbage of capital at risk because of probabilities which are tiny with very large confidence intervals. The end result is a massive pile of garbage which is likely not environmentally friendly.

  17. I am a retired blogger from Israel(IDF),I have a new FUNNY/HUMOR blog: and I am interested in a Reciprocal Links with your great blog,if it's possible,please.I think Humor/Satire is important to people,anywhere,anytime,any blog,even in serious and political blogs or any stuff...Best wishes,David.

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