Friday, October 16, 2015

Bank of England Head Makes a Conservative, Economic Case for Action on Climate Change

Bank of England Governor Mark Carney has warned that firms and regulators can no longer avoid addressing global climate change / Photo: James Oxley, CC BY-ND 2.0

A few weeks ago, Bank of England Governor Mark Carney, who also chairs the Financial Stability Boardgave a speech at Lloyd's of London regarding the economic impacts and challenges of global climate change.  Given his audience, he also paid particular attention to how climate change has impacted the insurance industry, and will continue to do so.

Despite plenty of disagreement on the particulars he advocates, Carney made a compelling case for corporations and financial firms to stop fighting the acknowledgement of climate change and start modifying practices NOW in order to smooth the transition, reduce the ultimate cost of combating climate change and adapting to it, and avoid not just ecological catastrophe, but economic catastrophe, as well.

It was a lengthy speech and covered a lot of ground.  For now, I'm just going to share the video and a much-abridged version of 
Carney's own words here, and save for another time my critiques of the erroneous assumptions he seems to make about corporations' ability to self-regulate and markets' ability to incorporate long-term risk considerations into current market prices for stocks and bonds.

Will any of the points Gov. Carney raised remotely impact ideology-driven U.S. Republicans' rhetoric around climate change?  We'll see.  At least a few officialsone mega-donor and some 54% of conservative Republican voters already seem to be listening.

First, the CONCLUSION:

Our societies face a series of profound environmental and social challenges.  The combination of the weight of scientific evidence and the dynamics of the financial system suggest that, in the fullness of time, climate change will threaten financial resilience and longer-term prosperity.

While there is still time to act, the window of opportunity is finite and shrinking. 31  ...  With better information as a foundation, we can build a virtuous circle of better understanding of tomorrow’s risks, better pricing for investors, better decisions by policymakers, and a smoother transition to a lower-carbon economy.


There is a growing international consensus that climate change is unequivocal. 2  Many of the changes in our world since the 1950s are without precedent: not merely over decades but over millennia.

Research tells us with a high degree of confidence that:

   > In the Northern Hemisphere the last 30 years have been the warmest since Anglo-Saxon times; indeed, eight of the ten warmest years on record in the UK have occurred since 2002; 3

   > Atmospheric concentrations of greenhouse gases are at levels not seen in 800,000 years; and

   > The rate of sea level rise is quicker now than at any time over the last 2 millennia. 4

Evidence is mounting of man’s role in climate change. Human drivers are judged extremely likely to have been the dominant cause of global warming since the mid-20th century. 5  While natural fluctuations may mask it temporarily, the underlying human-induced warming trend of two-tenths of a degree per decade has continued unabated since the 1970s. 6 ...

I have found that insurers are amongst the most determined advocates for tackling it sooner rather than later.  And little wonder.  While others have been debating the theory, you have been dealing with the reality:

   > Since the 1980s the number of registered weather-related loss events has tripled; and

   > Inflation-adjusted insurance losses from these events have increased from an annual average of around $10bn in the 1980s to around $50bn over the past decade. 7

The challenges currently posed ... pale ... compared with what might come.  The far-sighted amongst you are anticipating broader global impacts on property, migration and political stability, as well as food and water security. 8

So why isn’t more being done to address it?

A classic problem in environmental economics is the tragedy of the commons.  The solution to it lies in property rights and supply management. ...  [Th]e catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors – imposing a cost on future generations that the current generation has no direct incentive to fix.

That means beyond:

> the business cycle; 9

> the political cycle; and

> the horizon of technocratic authorities, like central banks, who are bound by their mandates.

The horizon for monetary policy extends out to 2-3 years. For financial stability it is a bit longer, but typically only to the outer boundaries of the credit cycle – about a decade. 10

In other words, once climate change becomes a defining issue for financial stability, it may already be too late. ...  [Paradoxically], as risks are a function of cumulative emissions, earlier action will mean less costly adjustment. 11

The desirability of restricting climate change to 2 degrees above pre-industrial levels 12 leads to the notion of a carbon ‘budget’, an assessment of the amount of emissions the world can ‘afford’.  Such a budget - like the one produced by the IPCC 13  - highlights the consequences of inaction today for the scale of reaction required tomorrow.

These actions will be influenced by policy choices that are rightly the responsibility of elected governments, advised by scientific experts.  In ten weeks representatives of 196 countries will gather in Paris at the COP21 summit to consider the world’s response to climate change. It is governments who must choose whether, and how, to pursue that 2 degree world.  ...

There are three broad channels through which climate change can affect financial stability:

- First, physical risks: the impacts today on insurance liabilities and the value of financial assets that arise from climate- and weather-related events, such as floods and storms that damage property or disrupt trade;

- Second, liability risks: the impacts that could arise tomorrow if parties who have suffered loss or damage from the effects of climate change seek compensation from those they hold responsible.  Such claims could come decades in the future, but have the potential to hit carbon extractors and emitters – and, if they have liability cover, their insurers – the hardest;

- Finally, transition risks: the financial risks which could result from the process of adjustment towards a lower-carbon economy.  Changes in policy, technology and physical risks could prompt a reassessment of the value of a large range of assets as costs and opportunities become apparent.

The speed at which such re-pricing occurs is uncertain and could be decisive for financial stability.  There have already been a few high profile examples of jump-to-distress pricing because of shifts in environmental policy or performance.

Risks to financial stability will be minimised if the transition begins early and follows a predictable path, thereby helping the market anticipate the transition to a 2 degree world.

... It stands to reason that general insurers are the most directly exposed to [climate-change-induced] losses.  Potential increases in the frequency or severity of extreme weather events driven by climate change could mean longer and stronger heat waves; the intensification of droughts; and a greater number of severe storms.  ...

[W]ork done here at Lloyd’s of London estimated that the 20cm rise in sea-level at the tip of Manhattan since the 1950s, when all other factors are held constant, increased insured losses from Superstorm Sandy by 30% in New York alone. 15 ...

Improvements in risk modelling must be unrelenting as loss frequency and severity shifts ...  Indeed, there are some estimates that currently modelled losses could be undervalued by as much as 50% if recent weather trends were to prove representative of the new normal. 18   In addition, climate change could prompt increased morbidity and mortality from disease or pandemics.

Such developments have the potential to shift the balance between premiums and claims significantly, and render currently lucrative business non-viable. ... In some extreme cases, householders in the Caribbean have found storm patterns render them unable to get private cover[age], prompting mortgage lending to dry up, values to collapse and neighbourhoods to become abandoned.

Thankfully these cases are rare. But the recognition of the potential impact of such risks has prompted a publicly-backed scheme in the UK – Flood Re[insurance] – to ensure access to affordable flood insurance for half a million homes now considered to be at the highest risk of devastating flooding.

This example underlines a wider point. While the insurance industry is well placed to adapt to a changing climate in the short-term, their response could pose wider issues for society, including whether to nationalise risk.  ...

‘Loss and Damage’ from climate change – and what to do about it – is now formally on the agenda of the United Nations Framework Convention on Climate Change, with some talking openly about the case for compensation. 22  These risks will only increase as the science and evidence of climate change hardens.  ...

The UK insurance sector manages almost £2tn in assets to match liabilities that often span decades. While a given physical manifestation of climate change – a flood or storm – may not directly affect a corporate bond’s value, policy action to promote the transition towards a low-carbon economy could spark a fundamental reassessment.

Take, for example, the IPCC’s estimate of a carbon budget that would likely limit global temperature rises to 2 degrees above pre-industrial levels.  That budget amounts to between 1/5th and 1/3rd world’s proven reserves of oil, gas and coal. 24  If that estimate is even approximately correct it would render the vast majority of reserves “stranded” – oil, gas and coal that will be literally unburnable without expensive carbon capture technology, which itself alters fossil fuel economics. 25

The exposure of UK investors, including insurance companies, to these shifts is potentially huge.
 19% of FTSE 100 companies are in natural resource and extraction sectors; and a further 11% by value are in power utilities, chemicals, construction and industrial goods sectors.  Globally, these two tiers of companies between them account for around one third of equity and fixed income assets.

On the other hand, financing the de-carbonisation of our economy is a major opportunity for insurers as long-term investors.  It implies a sweeping reallocation of resources and a technological revolution, with investment in long-term infrastructure assets at roughly quadruple the present rate. 26  For this to happen, “green” finance cannot conceivably remain a niche interest over the medium term.

There are a number of factors which could influence the speed of transition to a low carbon economy including public policy, technology, investor preferences and physical events. ...

From a regulator’s perspective the point is not that a reassessment of values is inherently unwelcome. It is not.  Capital should be allocated to reflect fundamentals, including externalities. ...  But ... an abrupt resolution of the tragedy of horizons is in itself a financial stability risk.  The more we invest with foresight; the less we will regret in hindsight. ...

Financial policymakers will not drive the transition to a low-carbon economy. It is not for a central banker to advocate for one policy response over another.  That is for governments to decide.

But the risks that I have outlined mean financial policymakers do, however, have a clear interest in ensuring the financial system is resilient to any transition hastened by those decisions, and that it can finance the transition efficiently ... our role can be in developing the frameworks that help the market itself to adjust efficiently. ...

That is why, following our discussions at the FSB last week, we are considering recommending to the G20 summit that more be done to develop consistent, comparable, reliable and clear disclosure around the carbon intensity of different assets. ...

Information about the carbon intensity of investments allows investors to assess risks to companies’ business models and to express their views in the market. ...  [A] framework for firms to publish information about their climate change footprint, and how they manage their risks and prepare (or not) for a 2 degree world, could encourage a virtuous circle of analyst demand and greater use by investors in their decision making.  It would also improve policymaker understanding of the sources of CO2 and corporate preparedness. ...

Given the uncertainties around climate, not everyone will agree.  Some might dispute the IPCC’s calculations. Others might despair that there will never be financial consequences of burning fossil fuels.  Still others could take a view that the stakes make political action inevitable.

The right information allows sceptics and evangelists alike to back their convictions with their capital.  It will reveal how the valuations of companies that produce and use fossil fuels might change over time.  It will expose the likely future cost of doing business, paying for emissions, changing processes to avoid those charges, and tighter regulation. ....

In any field, financial, scientific or other, the most effective disclosures are:

> Consistent - in scope and objective across the relevant industries and sectors;
> Comparable - to allow investors to assess peers and aggregate risks;
> Reliable - to ensure users can trust data;
> Clear - presented in a way that makes complex information understandable; and
> Efficient - minimising costs and burdens while maximising benefits.

Meeting these standards requires coordination, something the G20 and FSB are uniquely placed to provide.

The logical starting point is a co-ordinated assessment of what constitutes effective disclosure, by those who understand what is valuable and feasible.  

One idea is to establish an industry-led group, a Climate Disclosure Task Force, to design and deliver a voluntary standard for disclosure by those companies that produce or emit carbon.  Companies would disclose not only what they are emitting today, but how they plan their transition to the net-zero world of the future.  The G20 – whose member states account for around 85% of global emissions 28  – has a unique ability to make this possible.  ...

The Bank of England's full transcript of the speech can be reviewed here.

Selina Davis has a JD from the University of Washington, a BA in Economics, and two years of graduate study in economics.  She has worked extensively in law, politics, policy analysis, and all three branches of government.  Follow her on Twitter at @SelinaDavis73.

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