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Unintended consequences

The Dec 14 Wall Street Journal amplifies my warnings on the movement to de-fund fossil fuels by financial regulation, citing "climate risks." "The Senate Democrats’ Special Committee on the Climate Crisis recently issued a report detailing how the Fed and eight other regulatory agencies should penalize investment in fossil fuels and promote green energy. They claim financial ...

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The Dec 14 Wall Street Journal amplifies my warnings on the movement to de-fund fossil fuels by financial regulation, citing "climate risks." 
"The Senate Democrats’ Special Committee on the Climate Crisis recently issued a report detailing how the Fed and eight other regulatory agencies should penalize investment in fossil fuels and promote green energy. They claim financial institutions are underpricing the risk that carbon-intensive assets will become “stranded.”
Mind you, their worry isn’t about how climate change per se would devalue investments, which financial institutions already account for. They want a warning about the costs of government climate policies. “Because Congress has not advanced any comprehensive climate policies in the last decade, the market has not priced in the possibility of significant federal action,” the report notes."

As reported this is at least a refreshing breath of honesty. In all I have read (not everything, it's a mountain) of the BoE, ECB, BIS, OECD, IMF treatment of "climate risk," there is a vague insinuation that climate itself poses a "risk," which is utter nonsense. Beyond nonsense, it is a directive for banks to make up numbers in order to justify de-funding politically unpopular fossil fuel projects. (In case that's not obvious, climate is not weather. The tails of the weather distribution and their minor effect on the profitability of large corporations are better known than just about any other risk, at horizons where bank supervision and risk management operate.) Here, it is at least clear that the relevant "risk" is the risk that Congress or the administrative state will shut down businesses. 

Actually, if taken seriously, honestly and generally, I might be all for it. Yes! Let our financial regulators require that firms and the banks who fund them disclose and account for all of the political risks that future government action might take to harm them -- law, regulation, administrative decisions, and prosecution. Indeed, state every possible nitwit regulation, idiotic tariff (Dec 29 WSJ is a masterpiece of how arbitrary  administrative decisions make or break companies), or ridiculous law or politicized prosecution might harm the company or investment.  Let's make this really tough -- criminal penalties for failing to disclose ahead of time that, say, the government might challenge a decade-old merger, or decide with a secret algorithm that it doesn't like the interest rates you charged or who you hired. While we're disclosing financial risks, let's disclose the risk that a future Congress might remove the long list of subsidies and protections that your green projects live on. The long lists of well documented potential mischief would be edifying! 

OK, I'll stop dreaming. This isn't serious, it isn't about climate in any vaguely sensible cost-benefit way, it's about fossil fuels. It's about de-funding fossil fuels before alternatives are available at scale, by capturing the regulatory system because the people's elected legislators are not about to do it. (In the US.)

And it's really clever. Or sneaky. That the US Congress will take an action which strongly hurts the finances of fossil fuel companies is not a given. There are a few still who recognize, say, that fracking for natural gas has lowered US carbon emissions dramatically, and improved our economy and geopolitical situation. A ban on fracking, or on nuclear power (Germany) would be a clear disaster. Will Congress really do it? Will the Department of Energy or the EPA really go so far on their own? It's not likely, is it. 

Banks and bondholders have taken a sober look at just how much damage Congress is likely actually to impose. They don't think it's likely to happen. So the effort is clever: Try to get a financial run going ahead of time to avoid a risk that doesn't exist.

The unintended consequences   

The title of this post is "unintended consequences." Here is the real question: How is it that the government has the power to force the financial system de-fund politically unpopular industries, under the guise that they might be "risky?" Do we not have a nearly constitutional right to bet on an industry, be wrong, and lose a lot of money? When everyone else is shunning so-far legal fossil fuels fearing government action, do we not have a right to take the contrarian bet? 

Well, no. And here is the really interesting story of a dramatic expansion of administrative power in only 10 years, all unintended. But once the avalanche gets going it keeps going. 

It really goes back to 1933. After that bank run, the US chose not to follow the "Chicago plan," narrow deposit taking and equity-financed banking, and instead chose the path of deposit insurance, and bank asset risk regulation. With each crisis, we doubled down. 

2008 was the most recent immense crisis, and basically a run. Once again, we needed to fix one of two things: either financial institutions have to get their money by issuing equity and borrowing long-term in ways that cannot run, or an array of bureaucrats has to monitor how they invest their money, making sure they don't take too much "risk." Our government doubled down on the second option. (Newcomers: A more detailed version of this little old lady who swallowed a spider history is in "toward a run-free financial system" and "a blueprint for effective financial reform.") 

And over the next 10 years the ambition of our regulators to regulate "risks" expanded dramatically. If they regulate only banks, financial activity moves outside the banking system, which it did. So now the government "monitors" and regulates "risks" throughout the "financial system." (Scare quotes indicate fuzzy words.) 

And  the early restriction that risk had somehow to be "systemic," threatening not an individual loss of money but a systemwide panic, faded away. "Systemic" now means "anywhere in the system," not "threatening a run to the entire system, not individual failures." At the cost of repetition, let me emphasize this point. As I travel around and read the output of central banks and other institutions, in 10 short years it is now universally understood that regulators job is to "monitor risks" everywhere in the financial system. not just those risks that might conceivably cause a run, panic, or crisis. 

For example, a company wishing to borrow to finance a (heavens) fracking project to bring low-carbon natural gas to market or a pipeline, to avoid shipping oil in rail tank cars, frozen out of banks, might simply sell corporate bonds. Those bonds would be bought by a mutual fund or exchange-traded fund. That poses zero risk of a run. But mutual funds too must disclose "risks," and can be effectively regulated. 

The ability of the Fed to tell banks what to do, to shun fossil fuels if the Fed so desires is essentially total and arbitrary. But the  danger is not just the Fed, which the WSJ article points to. As Michael Norbert writes in Forbes the larger target is the FSOC, 

Environmental activists are hopeful that Janet Yellen, Joe Biden’s pick for Treasury Secretary, will lead a major shift in public policy toward actively addressing climate change. ...activists are calling for her to use the Financial Stability Oversight Council (FSOC) in the “campaign against global warming.”...

What, exactly, is the FSOC?

Created by the 2010 Dodd-Frank Act, it is a council of all the major federal financial regulators. The Treasury Secretary serves as the council’s chair. Section 112 of Dodd-Frank defines the FSOC’s basic purposes, such as identifying risks to U.S. financial stability that come from “outside” the financial marketplace, and responding to “emerging threats” to financial stability.

However, the Dodd–Frank Act does not spell out how the council may respond to emerging threats to financial stability. In fact, it doesn’t even define emerging threats or, for that matter, financial stability. This sort of ill-defined government authority is dangerous in its own right.

Separately, section 120 of Dodd-Frank authorizes the council to recommend more stringent regulations for an “activity”— if the council determines that the “conduct, scope, nature, size, scale, concentration, or interconnectedness” of the activity could “increase the risk of significant liquidity, credit, or other problems spreading” through other companies or markets. ...

Thus a Biden administration would have the authority to restrict/redirect practically any climate-related economic activity based on nothing more than a belief that it might cause “problems” in the future.

If you are iffy on climate goals, social-justice goals are not far behind. Michael again

Congress should never have given such authority to unelected officials running regulatory agencies and, arguably, should not have such power to begin with.

Congress did have, I think, a fairly narrow concept in mind. Nobody really knew back then just how a "systemic run" evolves, so it hoped with vague language that the FSOC and subsidiary agencies would figure it out and define a limited scope. That is the vain hope. The institutions instead have interpreted their mandate for action ever more broadly. And here we are. 

Michael is thoughtfully even handed

Many climate activists will probably scoff at this objection, but the FSOC could just as easily make life miserable for the companies that they like. For instance, the FSOC could slap solar energy companies (or their investors) with stringent regulations and fees. In the last year, two major solar companies filed bankruptcy. These cases provide concrete examples of renewable energy companies posing a risk to “financial stability,” thus justifying (under Dodd-Frank) virtually any new regulation that the council comes up with.

It is common to both parties, but strikes me as especially common on the left to forget that someday you might lose an election and your opponents use the tools you just created against you. Filibuster anyone? 

But this is an important point. For my objection has nothing to do with climate policy, it is an objection to untrammeled power that can de-fund anyone's crusade. A new Republican administration might de-fund industries that trade with China, as both administrations have de-funded pot farmers, for-profit schools, payday lenders, and a range of other unpopular industries. Who is next? 


John H. Cochrane
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!

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