Central banks can prevent the next climate-induced financial crisis

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In 2008, as major banks began to fail Across Wall Street and the housing and stock markets crashed, the nation has seen how crucial financial regulation is to economic stability – and how quickly the the consequences can be linked through the economy when regulators are asleep at the wheel.

Today, another economic risk is looming: climate change. Again, the extent of its adverse effects on economies will very much depend on the reaction of financial regulators and central banks.

The impact of climate change on economies is not always obvious. Mark Carney, former Governor of the Bank of England, identified a series of risks related to climate change in 2015 that could shake the financial system. Rising costs of extreme weather, lawsuits against companies that have contributed to climate change and falling values ​​of fossil fuel-related assets could all have an impact.

Nobel Prize-winning American economist Joseph Stiglitz agrees. In a recent interview, he argued that the impact of a large increase in carbon price – that governments charge corporations 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 affect the wider economy.

Our research as environmental economists and macroeconomists confirms that the effects of climate change and certain policies needed to stop it could have significant implications for financial stability, if preventive measures are not taken. Public policies tackling, after years of delay, the fossil fuel emissions that are causing climate change could devalue energy companies and depress investments held by banks and pension funds, as well as sudden changes in consumption habits.

The good news is that regulators have the capacity to address these risks and pave the way for the safe implementation of ambitious climate policy.

Climate stress banks

First, regulators can require banks to publicly disclose their climate change risks and stress test their ability to manage change.

The Biden administration recently introduced a executive decree on climate-related financial riskswith the goal of encouraging U.S. companies to assess and publicly disclose their exposure to climate change and future climate policies.

In the United Kingdom, large companies already must disclose their carbon footprintand the UK is pushing for all major economies to follow its lead.

The European Commission has also proposed new rules for companies to account for climate and sustainability in their investment decisions across a wide range of industries in its new Sustainable finance strategy published on July 6. This strategy builds on a previous sustainable growth plan from 2018.

The impact of a sharp rise in carbon prices could trigger a new financial crisis.

Carbon disclosure represents a crucial ingredient for “climatic stress tests“, assessments that assess how well prepared banks are for potential shocks from climate change or climate policy. For example, a recent study by the Bank of England determined that banks were unprepared for a carbon price of $150 a tonne, which he deemed necessary by the end of the decade to meet international requirements. Paris Climate Agreementher goals.

the European Central Bank conducts stress tests to assess the resilience of its economy to climate risks. In the United States, the Federal Reserve recently created the Financial Stability and Climate Committee with similar goals in mind.

Monetary and financial policy solutions

Central banks and academics have also proposed several ways to combat climate change through monetary policy and financial regulation.

One of these methods is “green quantitative easing“, which, as 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, he would only buy “green” or environmentally friendly assets. Green quantitative easing could encourage investment in climate-friendly projects and technologies such as renewable energy, although researchers have suggested that effects may be short-lived.

A second policy proposal is to modify existing regulations to recognize the risks that climate change poses to banks. Banks are generally subject to minimum capital requirements ensuring banking sector stability and mitigating the risk of financial crises. This means that banks must hold a minimum amount of liquid capital in order to lend.

Integrating environmental factors into these requirements could improve banks’ resilience to climate-related financial risks. For example, a “brown penalty factor“would require higher capital requirements on loans to carbon-intensive industries, discouraging banks from lending to these industries.

If climate policy is implemented gradually, economic risks can be low and financial regulation can manage them.

Overall, these existing proposals have in common the objective of reducing economy-wide carbon emissions and simultaneously reducing the exposure of the financial system to carbon-intensive sectors.

The Bank of Japan announced a new climate strategy July 16, which includes offering interest-free loans to banks lending to environmentally friendly projects, supporting green bonds and encouraging banks to disclose their climate risk.

The Federal Reserve has begun to study these policies, and it has created a panel focused on the development of a climatic stress test.

lessons from economists

Often, policy-making follows scientific and economic debates and advances. With financial regulation of climate risks, however, it is arguably the opposite. Central banks and governments are offering new policy tools that have not been explored for a very long time.

A few research papers published over the past year provide a number of important insights that can help guide central banks and regulators.

They do not all come to the same conclusions, but a general consensus seems to be that financial regulation can help address large-scale economic risks that the abrupt introduction of a climate policy could create. A paper found that if climate policy is implemented gradually, economic risks can be low and financial regulation can manage them.

Financial regulation can also help accelerate the transition to a cleaner economy, according to research. An example is subsidizing loans to climate-friendly industries while taxing loans to polluting industries. But financial regulation alone will not suffice to effectively combat climate change.

Central banks will have a role to play as countries try to manage climate change in the future. In particular, prudent financial regulation can help prevent barriers to the kind of aggressive policies that will be needed to slow climate change and protect the environments for which our economies were built.

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