Central banks are catching on to the enormous threat of climate change

The heads of two major European central banks issued an open letter recently warning that climate change poses a significant financial risk to the global economy. The letter was co-signed by the Network for Greening the Financial System (NGFS), a group of 34 central banks, and emphasizes that the economic effects of climate change are already being felt globally. The authors of the letter were Bank of England governor Mark Carney and Francois Villeroy de Galhau, Bank of France governor. Their warning noted three areas of concern: physical, including immediate impacts from drought and storms; transitional, the cost of moving away from carbon industries in a sudden or disorderly manner; and liability, people seeking compensation for losses related to the first two.

Severe financial disruption — including a new financial crisis — could be part of that mix, according to Eric Orts, a Wharton professor of legal studies and business ethics, and Emanuele Campiglio, a professor of climate economics and finance at Vienna University of Economics and Business. Both experts recently spoke about the central bankers’ actions on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

Why are central bankers so interested in climate change issues? One reason is that serious effects from climate change now look much closer to the horizon than recently thought, said Orts, who is also director of Wharton’s Initiative for Global Environmental Leadership. Not long ago — when big climate trouble appeared to be 30-50 years away — there was little interest from bankers. Now, impacts are visible and “the window for making a significant transition in order to avoid radical crashes in the world, including financial crashes, is 10 to 12 years.” Given that central banks are responsible for financial stability, there is a newfound focus.

The U.S. is still not part of this central bank organization in part because it is so new, Orts added. But the signatories represent “a huge number of countries – you have China, Mexico, many European countries, etc., and the U.S. will be compelled to come into this.” China is one of the key leaders of the new process, noted Campiglio, who is also a visiting fellow at the London School of Economics.

Beyond the Paris Agreement

How should central banks help to defuse growing threats from climate change? There are a slew of ideas, noted Campiglio, from getting financial institutions to “disclose their exposure to climate-related risks” to using their financial instruments to help promote anti-climate change policies, such as “actively steering these massive amounts of financial assets towards green resources.”

While acknowledging that the Paris Agreement of 2015 has lost some momentum, Orts pointed out that action by members of the NGFS group can make some progress on combatting climate change separately. One item would be to get better reporting on the risks for companies. When we transition to a low-carbon economy “you’re going to have a lot of over-valued companies.” They are not going to be able to burn all of the coal, oil or gas assets they own or are now trying to discover. “So that’s going to have a significant effect on the economy,” Orts noted, including the potential for a financial crash.

What the central bankers are saying, according to Orts, is in effect: “We have to get ahead of that. We have to get better information about this. And in the best possible world you make a relatively smooth transition within the next 10-12 years, and the financial system will handle the disruption that’s inevitably going to occur.”

Not doing anything runs huge risks in Orts’ view, including massive regions of the world becoming uninhabitable. That’s not to say humans will become extinct, but it does mean tens of millions of people dying. In Europe, there could be 10 million to 20 million people seeking to migrate from southern regions. Such massive changes could lead to a “complete breakdown … a threat to the way our human civilization is organized.”

More people “are getting this” – they are taking note of extreme weather, hurricanes, wildfires and tornados, Orts added. But human beings are nevertheless “not set up” well to deal with more distant threats. Ultimately, somebody will find a way to short climate change in the markets and “will make a lot of money when the markets crash. But you’re making a lot of money at the end of the world. You’re making a lot of money in a terrible way.”

Finding the right role

Such reasoning contributes to central bankers joining academics, non-profits and politicians of different stripes and wanting to make transition plans now. The debate is increasing about what the proper role of central banks and financial regulators should be regarding climate change, said Campiglio. “[Are climate] interventions … within their mandates or not?” Another problem is that, so far, there is no macro-financial model available to represent the “transition dynamic, decarbonization pathways and financial variables.”

The potential financial risks are huge, Orts noted. In insurance and re-insurance, for example, “what happens to real estate valuations” with sea level rises and huge storms?

Liability risk probably gets the least attention, but it’s becoming more relevant, Campiglio noted. More and more lawsuits are being filed over liability issues by shareholders against companies and by local authorities against fossil fuel firms. So far, it’s unclear how the judicial system will treat these cases, he added.

But over time, investors might shift investment towards areas with fewer climate risks. “If they do it in a forward-looking manner, then this becomes a smooth transition. If they suddenly all realize for some reason that they are heavily exposed and they all try to sell at once, then we’re back to the financial crisis mode,” Campiglio said.

The point of the financial system is stability of human civilization, not just finances, Orts noted. Central bankers must move out of the comfort zone of familiar financial analysis models; they need to “actually take a position on how policy makers [should] handle this” If they don’t, then we are heading “for a financial crash.”

As for banks themselves, Campiglio added, “I don’t expect banks to reform from within. I would like central banks to be more active in steering them.”