In addressing the financial stability risks from climate change, financial policymakers face two paradoxes.
First, the future will be past. That is, climate change is the tragedy of the horizon which imposes a cost on future generations that the current one has no direct incentive to fix, with its catastrophic impacts felt beyond the traditional horizons of most actors including businesses and central banks. Once climate change becomes a clear and present danger to financial stability it may already be too late to stabilise the atmosphere at two degrees.
Second, success is failure. That is, too rapid a movement towards a low-carbon economy could materially damage financial stability. A wholesale reassessment of prospects, as climate-related risks are re-evaluated, could destabilise markets, spark a pro-cyclical crystallisation of losses and lead to a persistent tightening of financial conditions: a climate “Minsky moment”.
Building new markets – in climate transition and green finance – can help resolve the tragedy of the horizon. Over the past year, the focus of G20 Leaders and the aegis of the Financial Stability Board (FSB) have spurred important progress. The upcoming German presidency of the G20 now has a historic chance to mainstream climate finance and turn risk into opportunity.
To add impetus, there is a growing macroeconomic case for action. Throughout this decade, global growth has serially disappointed as the combination of huge debt overhangs, profound demographic changes and enormous uncertainties have weighed on activity. Nominal growth in the euro area, the UK and globally is running at half of its pre-crisis rate. Growth has been weak despite significant progress repairing the financial system, recent moves to somewhat expansionary fiscal policies in a number of countries, and years of unprecedented monetary policies.
Growth has been restrained, in part, by risk aversion stemming from elevated geopolitical, economic and policy uncertainty. Business investment across advanced economies has fallen by more than 2.5 percentage points of GDP, creating substantial investment shortfalls relative to pre-crisis trends. Businesses and investors appear to be hedging future disaster risk: equity risk premia are unusually high and government bond yields are consistent with very low growth for a very long time.
In this context, green finance is a major opportunity. By ensuring that capital flows into green and long-term projects, growth can be increased and financial stability promoted. By absorbing excess, global saving, equilibrium interest rates can be raised and macroeconomic stability enhanced.
Green Finance
For investors, green bond markets offer a stable, rated and liquid investment with long duration. For issuers, green bonds are a way to tap the huge US$100trn pool of patient private capital managed by global institutional fixed-income investors. For this to happen, however, green finance cannot conceivably remain a niche interest over the medium term – currently, green bonds account for less than 1% of holdings by global institutional investors.
Encouragingly, the green bond market is gradually gathering speed. Annual issuance rose from just $3bn in 2012 to $42bn in 2015. It could double this year with issuers ranging from US regional authorities raising funds domestically to invest in water projects, to Chinese and Indian corporates. Green bonds are being issued in a range of currencies, in major financial centres, including London, to finance a broad range of low carbon projects.
To reach escape velocity, market participants and public authorities must coordinate to deliver common green bond frameworks and definitions, and other necessary supporting infrastructure for local and cross-border markets. One specific initiative is the development of a ‘term sheet’ of internationally recognised standardised terms and conditions for green bonds. Authorities are now working with the private sector to that end.
Financial Stability
While the transition to a low-carbon economy has many opportunities, an abrupt resolution of the tragedy of the horizons is in itself a financial stability risk. Sudden changes in policy, technology and physical risks could prompt a reassessment of asset values as costs and opportunities become apparent.
An obstacle to a smooth adjustment has been the absence of information to help market participants make a market in climate-related financial risk.
In late 2015, at the request of G20 Leaders, the FSB established an industry-led Task Force, under the leadership of Michael Bloomberg. It is developing recommendations for voluntary, consistent, comparable, reliable and clear disclosures around climate-related financial risks for companies to provide information to lenders, insurers, investors and other stakeholders.
If firms were to make public sufficiently forward-looking and granular information, offering real insight into how climate-related risks and opportunities may impact a firm’s existing and future business lines, including against appropriate transition scenarios, a market in the transition to a two-degree world can be built.
This will help smooth price adjustments as opinions change, rather than concentrating them at a single climate “Minsky moment”. And it would allow feedback between the market and policymaking, making climate policy a bit more like monetary policy, with policymakers learning from markets’ reactions, and markets internalising policymakers’ objectives, strategies and instruments.
By mainstreaming green finance and managing what gets measured, we can help resolve the tragedy of the horizon.
Mark Carney is Chair of the Financial Stability Board and Governor of the Bank of England. This column is based on a speech given by Mr Carney at the Arthur Burns Memorial Lecture, Berlin, on 22 September 2016.