The Conversation
- Garth Heutel | Givi Melkadze | Stefano Carattini
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Authors
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Garth Heutel is Associate Professor of Economics, Georgia State
University
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Givi Melkadze is Assistant Professor of Economics, Georgia State
University
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Stefano Carattini is Assistant Professor in Economics, Georgia State
University
|
In 2008, as
big banks began failing
across Wall Street and the housing and stock markets crashed, the nation saw how
crucial financial regulation is for economic stability – and how quickly the
consequences can cascade
through the economy when regulators are asleep at the wheel.
Today, there’s another looming economic risk: climate change. Once again, how
much it harms economies will depend a lot on how financial regulators and
central banks react.
Climate change’s impact on economies isn’t always obvious. Mark Carney, the
former governor of the Bank of England,
identified a series of climate change-related risks
in 2015 that could shake the financial system. The rising costs of extreme
weather, lawsuits against companies that have contributed to climate change and
the falling value of fossil fuel assets could all have an impact.
Nobel Prize-winning U.S. economist Joseph Stiglitz agrees. In a recent
interview, he argued that the impact of a sharp rise in
carbon prices
– which governments charge companies for emitting climate-warming greenhouse
gases – could trigger another financial crisis, this time starting with the
fossil fuel industry, its suppliers and the banks that finance them, which could
spill over into the broader economy.
Our research as
environmental
economists and
macroeconomists confirms that both
the effects of climate change and some of the policies necessary to stop it
could have important implications for financial stability, if preemptive
measures are not undertaken. Public policies addressing, after years of delay,
the fossil fuel emissions that are driving climate change could devalue energy
companies and cause investments held by banks and pension funds to tank, as
would abrupt changes in consumer habits.
The good news is that regulators have the ability to address these risks and
clear the way to safely implement ambitious climate policy.
Climate-stress-testing banks
First, regulators can require banks to publicly disclose their risks from
climate change and stress-test their ability to manage change.
The Biden administration recently introduced an
executive order on climate-related financial risk, with the goal of encouraging U.S. companies to evaluate and publicly disclose
their exposure to climate change and to future climate policies.
In the United Kingdom, large companies already
have to disclose their carbon footprints, and the U.K. is pushing to have all major economies follow its lead.
The European Commission also proposed new rules for companies to report on
climate and sustainability in their investment decisions across a broad swath of
industries in its new
Sustainable Finance Strategy
released on July 6, 2021. This strategy builds on a previous plan for
sustainable growth from 2018.
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Mark Carney (right), former head of the Bank of England, has been
warning about the economic risks of climate change for several
years. The U.S. Federal Reserve, chaired by Jerome Powell (left),
has recently begun discussing it as well. AP Photo/Amber Baesler
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Carbon disclosure represents a crucial ingredient for “
climate stress tests,” evaluations that gauge how well-prepared banks are for potential shocks from
climate change or from climate policy. For example,
a recent study by the Bank of England
determined that banks were unprepared for a carbon price of US$150 per ton,
which it determined would be necessary by the end of the decade to meet the
international
Paris climate agreement’s goals.
The
European Central Bank
is conducting stress tests to assess the resilience of its economy to climate
risks. In the United States, the Federal Reserve recently established the
Financial Stability Climate Committee
with similar objectives in mind.
Monetary and financial policy solutions
Central banks and academics have also proposed several ways to address climate
change through monetary policy and financial regulation.
One of these methods is “
green quantitative easing,” which, like
quantitative easing
used during the recovery from the 2008 recession, involves the central bank
buying financial assets to inject money into the economy. In this case, it would
buy only assets that are “green,” or environmentally responsible. Green
quantitative easing could potentially
encourage investment
in climate-friendly projects and technologies such as renewable energy, though
researchers have suggested that the
effects might be short-lived.
A second policy proposal is to modify existing regulations to recognize the
risks that climate change poses to banks. Banks are usually subject to
minimum capital requirements
to ensure banking sector stability and mitigate the risk of financial crises.
This means that banks must hold some minimum amount of liquid capital in order
to lend.
Incorporating environmental factors in these requirements could improve banks’
resilience to climate-related financial risks. For instance, a “
brown-penalizing factor” would require higher capital requirements on loans extended to
carbon-intensive industries, discouraging banks from lending to such industries.
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Reducing fossil fuel use to slow climate change will affect oil
industry assets, like refineries, pipelines and shipping, as well
as the industry’s suppliers. Joe Raedle/Getty Images
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Broadly, these existing proposals have in common the goal of reducing
economy-wide carbon emissions and simultaneously reducing the financial
system’s exposure to carbon-intensive sectors. The Bank of Japan
announced a new climate strategy
on July 16, 2021, that includes offering no-interest loans to banks lending to
environmentally friendly projects, supporting green bonds and encouraging
banks to disclosure their climate risk.
The Federal Reserve has begun to study these policies, and it has
created a panel
focused on developing a climate stress test.
Lessons from economists
Often, policymaking trails scientific and economic debates and advancements.
With financial regulation of climate risks, however, it is arguably the other
way around. Central banks and governments are proposing new policy tools that
have not been studied for very long.
A few research papers released within the last year provide a number of
important insights that can help guide central banks and regulators.
They do not all reach the same conclusions, but a general consensus seems to
be that financial regulation
can help address large-scale economic risks
that abruptly introducing a climate policy might create.
One paper
found that if the climate policy is implemented gradually, the economic risks
can be small and financial regulation can manage them.
Financial regulation can also help
accelerate the transition
to a cleaner economy, research shows. One example is subsidizing lending to
climate-friendly industries while taxing lending to polluting industries. But
financial regulation alone will not be enough
to effectively address climate change.
Central banks will have roles to play as countries try to manage climate
change going forward. In particular, prudent financial regulation can help
prevent barriers to the kind of aggressive policies that will be necessary to
slow climate change and protect the environments our economies were built for.
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