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For the last four or five years, the general attitude of the market to central bank pronouncements about climate change has been a sort of mystified “what are they on about?”. In 2024, it seems to have become quite frighteningly clear.
As Larry Fink pointed out in 2021, although everyone likes to say that the financial sector should play a major role in combating global warming, this is actually quite a weird approach to take. If the government wants to regulate carbon dioxide emissions, then why not just regulate carbon dioxide emissions?
When companies that contribute to climate change are hit with massive fines and are forced to shut down plants, then the question of directing financial capital away from them is likely to look after itself.
On the other hand, if you try the three-cushions-in-off-the-green-ball bank shot approach, by messing around with capital ratios, then you push the business out of the regulated sector, ensuring that the least ethical companies are wholly financed by the least ethical investors.
As Fink put it:
Keep in mind, if a foundation or an insurance company or a pension fund says, ‘I’m not going to own any hydrocarbons,’ well, somebody else is, so you’re not changing the world.
In fairness to bank regulators, they have for the most part recognised this. The relevant Basel Standards are pretty clear that climate policy needs to be done for climate reasons, and that regulatory policy only really has a role to the extent that climate risks show up as financial threats to the stability of regulated institutions.
Up until this year, it’s been generally assumed across the industry that the biggest such risk is what’s termed “transition risk”. This is the same concept as that of the “orphan asset”; the idea that as the economy changes and climate regulations take hold, some industries will become unviable, and their investors and creditors will lose money.
This is a real risk, and there’s some evidence that it’s happening. One of the main points made in favour of “green quantitative easing” is that without some sort of restriction on holdings, there was a distinct risk that central banks would become the lenders of last resort to thermal coal producers.
And when the ECB started forcing European banks to demonstrate that they were measuring climate risks and taking them into account, they seem to have discovered something considerably more immediate and worrying. Which is that quite a lot of European banks don’t have accurate maps of flood and wildfire risk.
If all of your risk management is based on modelling — which is in turn based on historical data — then you might have a fairly significant problem in recognising risks that aren’t in the data set, because they haven’t happened before.
In September, the supervisors finally lost patience and started handing out fines. “Climate risk” isn’t just a matter of box-ticking on endless disclosures; it has a substantial element of “making sure that the collateral isn’t going to burn down or get washed away”.
But, of course, it isn’t just private sector banks that do things based on historical data or which are vulnerable to getting caught out by unprecedented risks. As ECB board member Frank Elderson pointed out in a recent speech, that’s the basis of inflation targeting too:
In addition to climate and nature hazards reducing the stock of natural and physical capital, the economic yield of this capital is also adversely affected.
To take just one example, crop yields have fallen because of more frequent extreme weather events. Estimates from ECB staff suggest that the heatwave in 2022 increased overall food price inflation by around 0.6 to 0.7 percentage points, with the impact lasting well into 2023.
At these magnitudes, this becomes a risk factor for overall price stability, especially because extreme weather events are becoming both more frequent and longer lasting. This is why, in our recent monetary policy communication, we explicitly acknowledge adverse weather conditions as risk factors for the inflation outlook.
In an economy that’s highly dependent on supply chains — which might also be vulnerable to fire and flood — it’s going to be increasingly important to know whether a deviation from target represents a forecast variance that needs to be addressed with monetary policy, or whether it’s a temporary spike caused by an important piece of infrastructure having been hit by an extreme weather event.
It’s not at all impossible that in a few years’ time, a material proportion of the debate at monetary policy committees will be taken up with discussion of how the economic forecasting model is going to interact with expectations of the next flood or wildfire season.
Which would, strangely, bring meteorology back into central banking. In the conference room at Threadneedle Street where Bank of England MPC meetings are held, there’s a sort of clock on the wall linked to a weathervane on the roof; it used to be important for the Court of the Bank of England to know which way the wind was blowing, because the number of ships docking at the Port of London would affect the market for bills of exchange.
In the new world, central banks might need a chief hydrologist alongside the chief economist.
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