In 2008, as big banks started to go bankrupt on Wall Street and as the housing and stock markets collapsed, the country saw how crucial financial regulation is to economic stability – and how quickly the the consequences can cascade across the economy when regulators are asleep at the wheel.
Today, another economic risk is looming: climate change. Once again, the damage this will do to economies will depend very much 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 undermine the financial system. Rising costs of extreme weather conditions, lawsuits against companies that have contributed to climate change, and declining value 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 sharp rise in carbon price – that governments charge companies for the emission of 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 have repercussions on the economy at large.
Our research as environmental economists and macroeconomists confirms that both the effects of climate change and some of the policies needed to stop it could have important implications for financial stability, if preventive measures are not taken. Public policies addressing, after years of delay, the fossil fuel emissions that are causing climate change could devalue energy companies and lead to a fall in investments held by banks and pension funds, as could sudden changes in consumption habits.
The good news is that regulators have the capacity to address these risks and clear the way to safely implement an ambitious climate policy.
Climate stress-test banks
First, regulators can require banks to publicly disclose their climate change risks and test their ability to manage the change.
The Biden administration recently introduced a decree on climate-related financial risk, with the goal of encouraging U.S. companies to assess and publicly disclose their exposure to climate change and future climate policies.
In the UK, large companies have already must disclose their carbon footprint, and the UK is pushing for all major economies to follow suit.
The European Commission has also proposed new rules allowing 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, 2021. This strategy is based on a previous sustainable growth plan from 2018.
Disclosure of carbon is a critical ingredient for “weather resistance tests», Assessments that measure banks’ preparedness for potential shocks from climate change or climate policy. For example, a recent Bank of England study determined that banks were not prepared for a carbon price of US $ 150 per tonne, which would be needed by the end of the decade to meet international demands Paris climate agreementthe objectives of.
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 Climate Committee with similar goals in mind.
Monetary and financial policy solutions
Central banks and academics have also proposed several ways to tackle 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, he would only buy “green” or environmentally friendly assets. Green quantitative easing could potentially encourage investment in climate-friendly projects and technologies such as renewable energy, although researchers have suggested that the the 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 required ensure the stability of the banking sector and mitigate the risk of financial crises. This means that banks must hold a minimum amount of liquid capital in order to be able to lend.
Incorporating environmental factors into these requirements could improve the resilience of banks to climate-related financial risks. For example, a “brown penalization factor”Would demand higher capital requirements on loans to carbon-intensive industries, discouraging banks from lending to these industries.
Broadly speaking, these existing proposals have in common the objective 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 July 16, 2021, 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 developing a weather resistance test.
Lessons from economists
Often, policy making lags behind scientific and economic debates and advances. With financial regulation of climate risks, however, it is arguably the other way around. Central banks and governments are offering new policy tools that have not been studied for a very long time.
A few research papers published over the past year provide a number of important information 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 sudden 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. One example is subsidizing loans to climate-friendly industries while taxing loans to polluting industries. But financial regulation alone will not be enough 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 avoid obstacles to the kind of aggressive policies that will be needed to slow climate change and protect the environments for which our economies were built.
Garth Heutel, associate professor of economics, Georgia State University; Givi Melkadze, assistant professor of economics, Georgia State University, and Stefano Carattini, lecturer in economics, Georgia State University