Climate financial risk is real and, like in 2008, the deniers are wrong

Unlike the 2008 global financial crisis – when banks were bailed out and global financial regulation overhauled – unmitigated climate change will lead to a crisis with irreversible outcomes. Climate-related financial regulation is urgently needed

Karl SchmeddersandRick van der Ploeg

Published: 3:30pm, 15 Sep, 2021

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In a recent commentary, John H. Cochrane, a Hoover Institution senior fellow, argues that “climate financial risk” is a fallacy.

His premise is that climate change doesn’t pose a threat to the global financial system because it, and the fossil fuel phase-out needed, are developments everyone knows are under way. He sees climate-related financial regulation as a Trojan horse for an otherwise unpopular political agenda.

We disagree. For starters, one should acknowledge the context in which regulation emerges. The Intergovernmental Panel on Climate Change’s sixth assessment report concludes with a high degree of certainty that the Earth’s climate is changing because of human activity.

Unlike the 2008 global financial crisis – when banks were bailed out and global financial regulation overhauled – unmitigated climate change will lead to a crisis with irreversible outcomes.

The question, as Cochrane puts it, is whether climate-related financial regulation can help avoid such outcomes. Although the answer is complex and currently incomplete, we argue that it can. Financial regulation to mitigate climate risk is worth pursuing; the stakes are too high to let the perfect become the enemy of the good.

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Consider some of the arguments about systemic financial risk and extreme climate events. First, we are told that stranded assets – particularly fossil-fuel assets – will become a fact of life, borne only by investors. But can we reasonably say the prevalence of this energy source should be left to market players alone, or that only investors will bear the costs?

Though per capita fossil-fuel consumption in countries such as the United States and Britain has declined since 1990, global consumption has risen by 50 per cent over the last 40 years.

Last year, China and India were the planet’s two largest coal-energy producers, relying on coal for 61 per cent and 71 per cent of their electricity, respectively. Their economies, and those of many developing countries, simply would not sustain a precipitous reduction in fossil-fuel energy.

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Cochrane also suggests there is no scientifically validated possibility that extreme climate events will cause systemic financial crises over the next decade, preventing regulators from assessing the risks on financial institutions’ balance sheets over a five- or 10-year horizon. But the sheer scale of the challenge should make us reconsider.

If temperature increases are to be kept within 2 degrees Celsius of pre-industrial levels this century, about 80 per cent of all coal, one-third of all oil, and half of all gas reserves must be left unburnt. All of the Arctic’s oil and the remainder of Canada’s oil sands – the world’s largest deposit of crude oil – must be left in the ground.

Finally, it is said that the technocratic regulation of climate investments cannot protect us against unmodelled tipping points. But this view ignores the extensive climate economics literature.

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The work of Nobel laureate economist William Nordhaus is widely referenced and his Dynamic Integrated Climate-Economy model has influenced many scientists’ and economists’ modelling of tipping points. The US government relies on these “integrated assessment models” to formulate policy and calculate the “social cost of carbon”.

This interdependency between economics, policy, politics, public opinion and regulation should be familiar. The overleveraging that generated the 2008 crash was an open secret but those able to do something about it were willing to deny the systemic risk.

One can find the same denialism in the climate debate. According to the Centre for American Progress, 139 current US Congress members “have made recent statements casting doubt on the clear, established scientific consensus that the world is warming – and that human activity is to blame”.

Cochrane makes an eloquent case for why policymakers should focus on creating coherent, scientifically valid policy responses to climate change and financial systemic risk separately, rather than pursuing climate financial regulation. But this isn’t an either/or choice. We need both kinds of policies, and we need coordination between them.

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We therefore should welcome the approach taken by US Treasury Secretary Janet Yellen’s Financial Stability Oversight Council, which has brought together leading regulators to prevent a repeat of the 2008 Wall Street meltdown.

Yellen has said she will use this body as her principal tool to assess climate risks and develop the disclosure policies needed to shift to a low-carbon economy.

Counterintuitive though it may be, climate-related financial regulation could usher in a new form of political accountability.

Such accountability was notably absent before and during the 2008 crisis. With political will, serious thinking about regulating climate financial risk could open up a fruitful debate for similar action on all neglected policy fronts.

Karl Schmedders is professor of finance at the Institute for Management Development

Rick van der Ploeg is professor of economics and research director of the Oxford Centre for the Analysis of Resource-Rich Economies at the University of Oxford

Copyright: Project Syndicate

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