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Climate risk to the financial system

Summary:
I wrote a piece for Project Syndicate, here,  on climate financial risk.  (This resulted from a presentation on a panel at the NBER summer institute risks of financial institutions meeting, program here. There should be a video version on YouTube but I can't find it. The panel discussion was excellent. You will recognize ideas from ...

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I wrote a piece for Project Syndicate, here,  on climate financial risk.  (This resulted from a presentation on a panel at the NBER summer institute risks of financial institutions meeting, program here. There should be a video version on YouTube but I can't find it. The panel discussion was excellent. You will recognize ideas from my earlier climate finance testimony. I recycle and refine. ) I titled it "an answer in search of a question," but PS didn't like that so we have the "fallacy" title. 

The essay: 

In the United States, the Federal Reserve, the Securities and Exchange Commission, and the Department of the Treasury are gearing up to incorporate climate policy into US financial regulation, following even more audacious steps in Europe. The justification is that “climate risk” poses a danger to the financial system. But that statement is absurd. Financial regulation is being used to smuggle in climate policies that otherwise would be rejected as unpopular or ineffective.  

“Climate” means the probability distribution of the weather – the range of potential weather conditions and events, together with their associated probabilities. “Risk” means the unexpected, not changes that everyone knows are underway. And “systemic financial risk” means the possibility that the entire financial system will melt down, as nearly happened in 2008. It does not mean that someone somewhere might lose money because some asset price falls, though central bankers are swiftly enlarging their purview in that direction. 

In plain language, then, a “climate risk to the financial system” means a sudden, unexpected, large, and widespread change in the probability distribution of the weather, sufficient to cause losses that blow through equity and long-term debt cushions, provoking a system-wide run on short-term debt. This means the five- or at most ten-year horizon over which regulators can begin to assess the risks on financial institutions’ balance sheets. Loans for 2100 have not been made yet.

Such an event lies outside any climate science. Hurricanes, heat waves, droughts, and fires have never come close to causing systemic financial crises, and there is no scientifically validated possibility that their frequency and severity will change so drastically to alter this fact in the next ten years. Our modern, diversified, industrialized, service-oriented economy is not that affected by weather – even by headline-making events. Businesses and people are still moving from the cold Rust Belt to hot and hurricane-prone Texas and Florida. 

If regulators are worried even-handedly about out-of-the-box risks that endanger the financial system, the list should include wars, pandemics, cyberattacks, sovereign-debt crises, political meltdowns, and even asteroid strikes. All but the latter are more likely than climate risk. And if we are worried about flood and fire costs, perhaps we should stop subsidizing building and rebuilding in flood and fire-prone areas. 

Climate regulatory risk is slightly more plausible. Environmental regulators could turn out to be so incompetent that they damage the economy to the point of creating a systemic run. But that scenario seems far-fetched even to me. Again though, if the question is regulatory risk, then even-handed regulators should demand a wider recognition of all political and regulatory risks. Between the Biden administration’s novel interpretations of antitrust law, the previous administration’s trade policies, and the pervasive political desire to “break up big tech,” there is no shortage of regulatory danger.

To be sure, it is not impossible that some terrible climate-related event in the next ten years can provoke a systemic run, though nothing in current science or economics describes such an event. But if that is the fear, the only logical way to protect the financial system is by dramatically raising the amount of equity capital, which protects the financial system against any kind of risk. Risk measurement and technocratic regulation of climate investments, by definition, cannot protect against unknown unknowns or un-modeled “tipping points.” 

What about “transition risks” and “stranded assets?” Won’t oil and coal companies lose value in the shift to low-carbon energy? Indeed they will. But everyone already knows that. Oil and gas companies will lose more value only if the transition comes faster than expected. And legacy fossil-fuel assets are not funded by short-term debt, as mortgages were in 2008, so losses by their stockholders and bondholders do not imperil the financial system. “Financial stability” does not mean that no investor ever loses money.

Moreover, fossil fuels have always been risky. Oil prices turned negative last year, with no broader financial consequences. Coal and its stockholders have already been hammered by climate regulation, with not a hint of financial crisis.  

More broadly, in the history of technological transitions, financial problems have never come from declining industries. The stock-market crash of 2000 was not caused by losses in the typewriter, film, telegraph, and slide-rule industries. It was the slightly-ahead-of-their-time tech companies that went bust. Similarly, the stock-market crash of 1929 was not caused by plummeting demand for horse-drawn carriages. It was the new radio, movie, automobile, and electric appliance industries that collapsed.

If one is worried about the financial risks associated with the energy transition, new astronomically-valued darlings such as Tesla are the danger. The biggest financial danger is a green bubble, fueled as previous booms by government subsidies and central-bank encouragement. Today’s high-fliers are vulnerable to changing political whims and new and better technologies. If regulatory credits dry up or if hydrogen fuel cells displace batteries, Tesla is in trouble. Yet our regulators wish only to encourage investors to pile on. 

Climate financial regulation is an answer in search of a question. The point is to impose a specific set of policies that cannot pass via regular democratic lawmaking or regular environmental rulemaking, which requires at least a pretense of cost-benefit analysis.

These policies include defunding fossil fuels before replacements are in place, and subsidizing battery-powered electric cars, trains, windmills, and photovoltaics – but not nuclear, carbon capture, hydrogen, natural gas, geoengineering, or other promising technologies. But, because financial regulators are not allowed to decide where investment should go and what should be starved of funds, “climate risk to the financial system” is dreamed up and repeated until people believe it, in order to shoehorn these climate policies into financial regulators’ limited legal mandates.

Climate change and financial stability are pressing problems. They require coherent, intelligent, scientifically valid policy responses, and promptly. But climate financial regulation will not help the climate, will further politicize central banks, and will destroy their precious independence, while forcing financial companies to devise absurdly fictitious climate-risk assessments will ruin financial regulation. The next crisis will come from some other source. And our climate-obsessed regulators will once again fail utterly to anticipate it – just as a decade’s worth of stress testers never considered the possibility of a pandemic.

*****

In retrospect I should have emphasized one point more strongly. Suppose you do believe that there is a "climate risk" to the financial system, a "tipping point" that can happen in the next 5-10 years. Suppose you believe that all our forest fires and floods are the result only of climate change, and might engulf the economy in the next decades.  If so, none of the currently advocated policies will do anything about it, especially those implemented by financial regulation.  The best the most aggressive climate policies hope to do is to limit the further increase in temperature by 2100.  Cutting fossil fuels out of debt markets, printing money to buy windmill and electric car bonds, a full on ESG effort in money management ... none of this will lower carbon dioxide to pre-industrial levels in the next 10 years. None of this will stop wildfires and floods in your great-grandchildren's lifetimes. 

It follows, that if financial regulators accept even the most climate-alarmist position, and for the goal of protecting the financial system, the policy must be one of rapid adaptation. Spend billions to clear the brush that burns, to build dikes, and certainly not to rebuild crumbling condos on the sea shore.  The mantra (I listen to NPR) that each disaster is the result of climate change does not mean that any currently envisioned climate policy is the best, or even vaguely effective, way to combat the chance of such disasters in our lifetimes. Or those of our great-grandchildren. 

That simple fact does not mean we should ignore the climate, but it does mean that if you truly believe these scenarios, an immense adaptation effort must be undertaken right now. If you don't follow to that conclusion, perhaps you don't really believe that there is a climate financial risk, and this is just a subterfuge to pass policies actually aimed at year 2100 temperatures and having nothing to do with climate risks, by radically un-democratic means. Which is my point. 


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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