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:

  2. The article presents a qualitative proposition that Western governments and governmental agencies (FOMC, Bank of England, etc.) are rushing into whole-sale change in the governance of Western societies on the basis of flimsy evidence of risk of societal collapse or failure in key sectors of the global economy.

    Qualitative arguments can advance a proposition only so far. Quantitative evidence is needed to take the proposition to a conclusion. One would want to know, for example, whether the consequences of rising sea-level is damages on the order of $14 to $27 trillion (year 2020-dollars) in the next 100 years (as 'some' analysts propound) or inconsequential as others caution, and what exactly the likelihood of such an event occuring in that time frame or ever might realistically be. Only when it can be shown that the losses and chances of loss are overstated, on a quantitatively sound basis can the qualitative argument against Western government over-reaction and excessive regulation hope to counter the current rush to over self-insure by force of regulation.

    Every journey begins with a first step.

  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?

    1. I find that I don't share your assessment of our host. Quite the contrary. The line of inquiry is veering into a set of topics that are highly contentious and very much relevant to questions of financial economics and the political economy. There is a lot of data; but not much in the way of quality data or relevant analyses of a hard-headed economic type. There is a need to get to the bottom of this so-called 'climate-change' issue before policy is set in stone. We need to be convinced that there is a real risk of catastrophic change which if it were avoidable would justify expending a certain part of future wealth (GDP) to avert. In this article, John has drawn attention to points that deserve greater examination; examination that isn't currently being undertaken by proponents of central government control. But, it's a very hard slog to get to the bottom this in a very short period of time with limited resources.

      But of one thing, we may be assured: that RCP-8.6 is not a likely future pathway though that is the pathway that most if not all apocalyptic scenarios are based upon. How to prove it?--that's the nub of the issue.

    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.

  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.


  9. An example of the arbitrary regulatory decisions that you refer to in your article is exemplified by a recent court case in the federal courts of Canada. Canada has one of the most arbitrary and repressive environmental review processes in the OECD. But recent changes in legislation has made that process more open to arbitrary and whimsical decisions by the federal minister. The minister initially decided against imposing a federal environmental permitting require on a thermal coal mine in Alberta that planned to expand production in partnership with a local North American Indian tribe on whose ancestral lands the mine is situated. Natural resources in Canada belong to the provincial governments under Canada's constitution, but federal environmental regulations can prevent a mine from being established or from expanding on its current production if the minister in his sole discretion finds that the mine or the expansion would have negative environmental impacts. The economic benefits are not considered by the minister. In this case, the minister, a John Wilkinson, MP, from North Vancouver, BC, initially decided that the mine expansion had no negative environmental impacts that warranted a federal permiting requirement. But, subsequently, under heavy lobbying by other tribes and by environmentalist/activists, and likely by his ministerial colleagues in the federal cabinet, he reversed course and denied the mine a permit to expand production. The mine owners and the North American Indian tribe that had an economic interest in the mine's sucess sued in Canada's federal courts and recently won a decions there that vacated the minister's decision. The federl judge found that the minister violated the tribe's constitutional right to meaningful consultation prior to the minister deciding on the permitting requirement.

    The article is found here:

    It makes for very interesting reading. The minister's response to the court's decision is revealing. Implicit in the court's decision is the conclusion that the minister's decision was biased and interested. Canada has become that sort of place recently that you only read about in journals which report on third-world countries.

  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?

  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!

  13. A 2012 article (Goldsplatt, and Watson) discusses the possibilities and pathways to a runaway greenhouse climate. The discussion is on a qualitative plane. The authors conclude that a runaway greenhouse climate is unlikely to occur even if fossil fuel combustion continues unabated. But, surface temperatures will continue to increase with higher CO2 partial pressures. The authors indicate that a runaway greenhouse effect is possible in the presence of higher solar output, or asteroid hit, or continuous asteroid showers that increase the energy input beyond the energy dissipation rate via thermal radiation emissions.

    So, a "good news, bad news" report. The good news: We are unlikely to destroy the climate. The bad news: We are unlikely to know whether we won't be likely to destroy the climate--climate-modelling is in its infancy and the physics is n-hard, where n is the number of degrees of freedom of the physical system and n ---> infinity pretty quickly the more realistic the modelling attempts to become.

    Conclusion: A political solution is unlikely to be informed; an optimal economic solution is incapable of being found, absent a physical model capable of predicting future climate behaviour realistically.

    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.

  14. Government policy is the largest component of "climate risk" to the financial system. The former Bank of England Governor, Mr. Mark Carney, is but one leading light in the global financial elite to continually draw our attention to the possibility (or, is it probability) of "stranded assets" arising from government policy decisions. A case in point is Borg-Warner Corporation. In a recent round-robin discussion of Borg-Warner's outlook, the corporation's CFO was informed by one participant that the corporation's terminal value is zero. Borg-Warner makes components for internal-combustion engines (e.g., turbo-chargers). The implication being that IC-engines have a limited future under anti-"climate change" government policy. The CFO was reportedly shocked at hearing that view. B-W is now transitioning away from IC-engine vehicle component manufacturing and curtailing capital investment in that product-market segment.

    The "American Economic Journal: Economic Policy", Vol. 13, Issue 3. August 2021 includes an article that examines, from a 'central planner's perspective' the optimal policy response to EV automobile manufacturing--when to end IC-engine automobile production. The article is based on standard maximization of social welfare under dynamic state conditions if the central planner has control over two manipulated variables--EV production and IC vehicle production. Appendices present the derivations of the governing equations for optimal social welfare under varying assumptions of social cost and policy alternatives. The abstract is set out below.

    (11) The Electric Vehicle Transition and the Economics of Banning Gasoline Vehicles Stephen P. Holland, Erin T. Mansur and Andrew J. Yates
    Electric vehicles have a unique potential to transform personal transportation. We analyze this transition with a dynamic model capturing falling costs of electric vehicles, decreasing pollution from electricity, and increasing vehicle substitutability. Our calibration to the US market shows a transition from gasoline vehicles is not optimal at current substitutability: a gasoline vehicle production ban would have large deadweight loss. At higher substitutability, a ban can reduce deadweight loss from vehicle mix and adoption timing inefficiencies. A cumulative gasoline vehicle production quota has smaller deadweight loss, and an electric vehicle purchase subsidy is more robust to regulator misperceptions about substitutability.

    * Main Paper --

    * Appendices --

    AEA membership gives free access.


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