’Green Swan’ Climate Events Can Rock the World’s Economies. How Banks Prepare for Them Could Save More Than Dollars
Japan faced crisis 10 years ago today, Friday afternoon. First came a 9.1-magnitude earthquake, the country’s largest ever recorded. This triggered an enormous tsunami that washed out entire cities. A tsunami caused an explosion at Fukushima Daiichi, a nuclear power station 150 miles north from Tokyo.
Immediate human toll aside, the disasters also threatened to plunge the world’s third largest economy into crisis. Masaaki Shinrakawa, the then-head of Bank of Japan scrambled to get his prosthetic jets ready. To ensure banks continued lending, the bank increased its asset and bond purchases by more than twice. It sold yen to stabilize the currency on foreign exchange markets in collaboration with other central bankers. Although the disaster left 20,000 dead or missing, Japan’s financial sector withstood the shock. If it hadn’t, Shirakawa said a month later, “the adverse effects on people’s lives and economic activity probably would have been even greater.”
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Shirakawa’s efforts presaged a growing consensus among today’s central bankers that they need to shore up the world’s financial systems against the economic impacts of climate change. The Japan disaster was a “black swan” event—rare, majorly disruptive and unexpected. But rising sea levels, droughts, fires, hurricanes and other extreme events from climate change—“green swans”—are inevitable.
With this foresight in mind, eight central banks as well as financial supervisors gathered together to create a plan. The Network for Greening the Financial System has 98 members. Some of these are testing whether regulatory policies can prepare the financial system for the physical destruction of property and asset-value loss, rising insurance premiums, and economic speed bumps such as higher energy prices and increased taxes on greenhouse gas emissions. “[Central banks] realize the need to do things now to recognize the existence of risks of climate change and how they impact firms and people,” says Natalia Ospina, head of policy analysis at the London-based Sustainable Policy Institute at the Official Monetary and Financial Institutions Forum (OMFIF).
Unlike governments, central banks—which oversee national monetary policy—can’t issue targeted climate policies like clean-energy subsidies or carbon taxes. However, they are able to modify banking regulations in order to help commercial banks hedge against their climate change risks. This may encourage them to do more business alongside greener businesses. (Story below graphic.
It is unclear how far central bankers can and should support these efforts. Central bankers are not elected, and they have mandates that grant them autonomy when it comes to, say, managing inflation, but they’re not meant to pick favorites in an open market. This is a particularly important issue in the U.S. Although the nation’s central bank, the Federal Reserve, joined the NGFS in December and later formed a committee to explore climate risks to financial stability, it also intends to be neutral in the market.
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“We have a responsibility to think about how climate change impacts our existing mandates around things like safety and soundness, financial stability or monetary policy,” said Kevin Stiroh, head of the supervision group at the New York Federal Reserve, at an OMFIF talk in April. “It’s a long-standing Fed position that banks make their own decisions about which legal businesses they engage with.”
Numerous heads of central banks, including Christine Lagarde, president of the euro zone’s, have prioritized climate. “The most important tools that are needed lie outside of our mandate,” she said in January, “but the fact that we are not in the driving seat does not mean that we can simply ignore climate change, or that we do not play a role in combatting it.” What that role could entail remains fuzzy. Certain central banks have explicitly mentioned climate change in their mandates. Megan Greene is a Kroll global chief economist and worries that they might go too far. “If they actually use their monetary policy tools to address climate change, then they are inherently picking winners and losers,” she says. “They’re still pretty wary of that.”
Most central banks have not yet identified the climate risk. They’re evaluating their own portfolios and asking—but typically not yet mandating—commercial banks to disclose which loans and assets are tied to carbon-intensive sectors or are vulnerable to green swan events. Climate-progressive central banking systems are using this information to run predictive models in order to predict the performance of financial institutions under various climate scenarios. The stress tests may eventually result in policies such as requiring capital to be held by banks that are more vulnerable to climate change. Since banks earn money through lending and not capital buffers they may be more inclined to partner with greener businesses and increase interest rates for loans to those that are less reputable. Businesses could be pushed to reduce their carbon footprint and check their risk.
For now, the financial world is working to assess what is “green” and what is “dirty.” Without that framework, it’s hard to do things like peg interest rates or collateral requirements to environmental friendliness. International commercial banks also have noticed that climate-risk assessments can be inconsistent across different countries. This creates a level playing field. Finding common ground won’t be easy, as there are at least 200 climate-risk frameworks across 40 countries, according to an International Monetary Fund analysis. On top of it all, central banks generally forecast in quarterly time frames—not the decades it will take to achieve net-zero carbon emissions.
With the debates over which assets are green vs. dirty, how to uniformly calculate them and what the climate scenario will actually be in decades’ time, modeling climate exposure is like baking from a recipe that lists neither all the ingredients nor standard measuring units nor oven temperature. The clock is ticking down, just like a baker. “We’ve not even completed the exploratory phase yet,” said Sarah Breeden, executive director for financial stability and risk at the Bank of England, at an OMFIF conference in September. “However, we do have a code red for humanity.”