Key takeouts

• What is the report about? The focus of the report is  primarily on the role of central banks in 'preserving financial stability' in the 'age of climate change'.
• Why are central banks concerned about climate change? The report identifies climate change as unequivocally representing a risk to financial and price stability and therefore, consistent with their current mandates, a key concern for central banks that should be integrated into financial stability monitoring and financial supervision.  
• The seriousness of the threat: Climate risk could trigger the next global financial crisis
  • What is a 'green swan' event? The 'green swan' label is based on, and is similar to, the concept of the 'black swan' event developed by Nassim Nicholas Taleb. However, green swans differ in a number of respects including (among others) that were such an event to occur, the causes of the crisis may be irreversible and the consequences more devastating (because more far-reaching).
  • A green swan event could trigger the next GFC? One example of the ways in which a green swan event could potentially trigger the next global financial crisis is if fossil fuel reserves were to become 'stranded assets' (due to a too-rapid transition to a low-carbon economy). Were this to occur, the BIS suggests that it could trigger a 'fire sale' the knock on effects of which could 'potentially' trigger a financial crisis.
• A new approach to measuring climate risk is required: The report cautions that traditional backward-looking risk assessments and existing climate-economic models cannot accurately predict the form that climate-related risks will take and as such, a shift in thinking and the development/adoption of forward-looking modelling and scenario-based methodologies (as advocated by the TCFD) is required. The report notes that there is emerging consensus among central banks/supervisors that this shift is necessary, as well as growing acceptance of the need to implement mandatory disclosure.
• Central banks shouldn't be relied on to provide a complete solution, collective action is required: The report cautions that 'relying too much on central banks would be misguided for many reasons', primarily because 'the instruments that central banks and supervisors have at their disposal cannot substitute for the many areas of interventions that are needed to transition to a global low-carbon economy'.  

• What role should central banks play? Chapter 4 of the report argues that the integration of climate-related risks into prudential regulation and (to the extent possible) into the relevant aspects of monetary policy will not of itself, 'suffice to shield the financial system against green swan events'. However, the report does not suggest that central banks seek to 'replace' governments or private actors by taking direct climate action (despite mounting pressure on central banks to do so) or that they stop at improving the way in which they measure climate risk. Rather, BIS argues that central banks should take a pro-active approach to calling for climate action, in coordinating actions by other players and in 'framing the debate'.  

Introduction

The Bank of International Settlements (BIS) has released a report — The green swan — Central banking and financial stability in the age of climate change — which considers the role of central banks, regulators and supervisors in 'preserving financial stability' in the 'age of climate change'. 

Ultimately BIS cautions that 'relying too much on central banks [to address climate change] would be misguided'.  Instead, the report makes clear that collective action (including action from governments, private actors and others) is required. 

In this context, the report argues that central banks should: integrate climate risk into prudential regulation and (to the extent possible) into the relevant aspects of monetary policy; be more proactive in calling for climate action; and take an active role in coordinating the actions other 'other players'.  'An important contribution of central banks is to adequately frame the debate and thereby help promote the mobilisation of all efforts to combat climate change' BIS writes.

Structure of the report

The report is broken into five chapters.  

• Chapter 1 outlines the 'climate emergency'
• Chapter 2 explains how climate change is a threat to global financial and price stability and the changes in thinking required to measure the the threat
• Chapter 3 assesses the methodological strengths and weaknesses of the various approaches to measuring climate risk
• Chapter 4 explains that addressing climate risk requires collective action and the role central banks might play in this context (beyond improving the way in which they measure climate stability).
• Chapter 5 concludes by outlining how financial and price stability and climate stability can be considered as two (increasingly) mutually dependent public goods

A high level summary of some of the key points raised in the report is below.

Why are central banks concerned about climate change? 

The report identifies climate change as unequivocally representing a risk to financial and price stability and therefore, consistent with their current mandates, a key concern for central banks.  'Climate change is a source of financial (and price) instability: it is likely to generate physical risks related to climate damages, and transition risks related to potentially disordered mitigation strategies.  Climate change therefore falls under the remit of central banks, regulators and supervisors, who are responsible for monitoring and maintaining financial stability' the report states.

Further to this, the report identities the two 'main channels' through which climate change could impact financial stability as physical risks (the rising economic costs and financial losses due to the increasing frequency and severity of climate related weather events) and transition risks (the uncertain impacts that could result from a too-rapid low carbon transition). In turn, BIS explains that each of these could manifest as credit risks, market risks, liquidity risks, operational risks and insurance risks.    

The seriousness of the threat: Climate risk could trigger the next GFC 

The report argues that a 'green swan' event could potentially have systemic consequences for the global financial system and even trigger the next financial crisis.  

What is a 'Green swan' event?

BIS explains (in Box A p3) that the 'green swan' label is based on the concept of the 'black swan' developed by Nassim Nicholas Taleb. Black swan events have three characteristics: 1) they are unexpected and rare (ie outside the 'realm of regular expectations); 2) their impacts are wide-ranging or extreme; and finally, 3) they can only be explained after the fact.   

Though 'green swans' share many of these characteristics, BIS explains, they differ in three key respects: 1) there is certainty about the need for ambitious actions to address climate change risks notwithstanding the uncertainty around the timing and nature of impacts of climate change; 2) 'climate catastrophes are even more serious than most systemic financial crises' ie BIS considers that the risks of climate change could 'pose an existential threat to humanity'; and 3) climate risks is more complex that the risks associated with black swan events in that 'the complex chain reactions and cascade effects associated with both physical and transition risks could generate fundamentally unpredictable environmental, geopolitical, social and economic dynamics'.

Further to this, the causes of green swan events may also be irreversible.  

How could a green swan event trigger another GFC?

The report suggests that 'green swan' events 'could be behind the next systemic financial crisis'.  

BIS suggests that one way in which this could occur, is through a too-rapid transition to a low-carbon economy. For example, BIS suggests that 'a rapid and ambitious transition' would mean that a large fraction of proven reserves of fossil fuel cannot be extracted. They would then be 'stranded assets'. The report suggests that 'an archetypal fire sale might result if these stranded assets suddenly lose value, potentially triggering a financial crisis'.  

In this instance, BIS adds 'there would be little ground for central banks to rescue the holders of assets in carbon-intensive companies. While banks in financial distress in an ordinary crisis can be resolved, this will be far more difficult in the case of economies that are no longer viable because of climate change. Intervening as climate rescuers of last resort could therefore affect central bank’s credibility and crudely expose the limited substitutability between financial and natural capital.

A new forward-looking, scenario based approach to risk modelling is required

BIS explains that given climate change is both fundamentally unpredictable and 'nonlinear,' traditional backward looking risk assessment models are unable and unsuited to predicting the future systemic risk it poses. In particular, backward looking risk models based on historical data and assumptions that shocks are normally distributed, are unable to predict 'green swan' events.

As such, the report argues that a change in thinking (what is referred to in the report as an 'epistemological break') and shift towards forward-looking risk approaches, based on scenario based analyses (as advocated by the Task Force on Climate-related Financial Disclosures (TCFD)) is required.   

Emerging consensus?

BIS writes that there is emerging consensus among central banks, supervisors and practitioners involved in climate related risks that this shift is necessary, and that it is beginning to be integrated into prudential regulation in 'several jurisdictions'. In addition, BIS considers that there is also growing acceptance that 'mandatory disclosure should be implemented to strengthen and systematise the integration of climate related risks'.  

Further, the report notes that 'discussions have emerged with regard to how the three pillars of the Basel Framework' could integrate climate related risks'.  

Limitations?

The report makes clear that forward-looking scenario based analysis is 'only a partial solution to apprehend the risks posed by climate change for financial stability' due both to the 'deep uncertainties involved' and the fact that no 'single model or scenario can provide a full picture'.  

Also, BIS acknowledges that in the absence of system-wide action, 'climate-related risks will remain largely unhedgeable'.  

Central banks cannot afford to stop at measuring climate risk

The report emphasises that immediate changes are required. 'Exceeding climate tipping points could lead to catastrophic and irreversible impacts that would make quantifying financial damages impossible. Avoiding this requires immediate and ambitious action towards a structural transformation of our economies, involving technological innovations that can be scaled but also major changes in regulations and social norms' the report states'.

BIS explains that central banks are faced with a difficult choice.

If they 'sit still and wait for other government agencies to jump into action' they risk, exposing themselves to the risk of not being able to deliver on their mandates of financial and price stability. For example, BIS suggests that in the worst case scenario, 'green swan events may force central banks to intervene as "climate rescuers of last resort" and buy large sets of devalued assets [ie stranded assets (unused fossil fuel reserves)], to save the financial system'.

On the other hand, BIS considers that it would be inappropriate for central banks to act to address the lack of action by governments and private actors. 'Central banks cannot (and should not) simply replace governments and private actors to make up for their insufficient action, despite growing social pressures to do so.  Their goodwill could even create some moral hazard. In short, central banks, regulators and supervisors can only do so much (and many of them are already taking action within their mandates), and their action can only be seen as enhancing other climate change mitigation policies' BIS writes.

As such, BIS cautions that 'relying too much on central banks would be misguided'.  

Central Banks need to be proactive in calling for and coordinating climate action

The report argues that action on the following issues is required to address the threat climate risk poses to financial stability: pricing carbon; long-termism and sustainable finance; coordination between green fiscal policy, prudential regulation and monetary policy; international monetary and financial coordination and reforms; and integration of natural capital into national and corporate systems of accounting.  This necessarily requires collective action.  

BIS argues that central banks have a role to play (primarily) by coordinating measures to directly 'fight climate risk' by 'other players' (eg governments, the private sector, civil society and the international community) through what the report describes as the 'five Cs': 'contribute to coordination to combat climate change'.  

'This coordination task is urgent since climate-related risks continue to build up and negative outcomes could become irreversible. There is an array of actions to be consistently implemented. The most obvious ones are the need for carbon pricing and for systematic disclosure of climate-related risks by the private sector' BIS states.

In addition, it's suggested that central banks have a role to play in 'framing' the debate, thereby promoting  'mobilisation' around climate risk.

Other 'essential' actions?

Other actions identified in the report, which are acknowledged to be 'difficult to take' yet 'essential' to preserving long term financial stability include: a) exploring new policy mixes (fiscal-monetary-prudential) that can better address the climate imperatives ahead and that should ultimately lead to societal debates regarding their desirability; b) considering climate stability as a global public good to be supported through measures and reforms in the international monetary and financial system; and c) integrating sustainability into accounting frameworks at the corporate and national level.

Social acceptance for combating climate change relies on fair distribution of costs/benefits of mitigation strategies

BIS observes that the risks and adaptation costs of climate risk mitigation strategies, 'fall disproportionately on poor countries and low income households in rich countries.' In consequence, sociopolitical backlashes against climate action are expected to continue unless there is a 'clear indication' of how the costs/benefits of climate mitigation strategies will be 'distributed fairly and with compensatory transfers'.  

As such, BIS argues that 'the needed broad social acceptance for combating climate change depends on studying, understanding and addressing its distributional consequences'. 

Response: A level of scepticism?

The AFR reports that Treasurer Josh Frydenberg has rejected the suggestion that in the worst case scenario, central banks may have to act as rescuers of last resort. 'I can't see that happening' The AFR quotes Mr Frydenberg as saying. 

Likewise, the AFR reports that former Reserve Bank of Australia board member Warwick McKibbin considers that the chances of such an extreme situation occurring is unlikely. The AFR quotes Mr McKibbin as saying that central banks, would 'only in the extreme case that involves a systemic problem for the financial system which is highly unlikely to happen'.  

[Sources: BIS media release 20/01/2020; Bank of International Settlements report: The Green Swan, Central banking and financial stability in the age of climate change January 2020; [registration required] The Australian 21/01/2020; The SMH 20/01/2020;  International Business Times 20/01/2020; [registration required] The AFR 22/01/2020; Investor Daily 21/01/2020]