The Teenager and the Electric Car: The Path to Financial Transition in a Green Economy

Two related events of note have occurred in the past month. First, Tesla’s market capitalization reached $100 billon in the last week of January, making it the most valuable automotive company ever, more valuable than GM and Ford combined.  Second, Greta Thunberg, the Swedish teenage climate change activist stole the limelight at the 2020 World Economic Forum’s Davos meeting of the world’s financial and political elites, (aka the Globalists; “Woodstock”).  These developments are harbingers of things to come on the climate change front, illustrating the fact that the powerful confluence of global public opinion and market forces could be at the center of a major shift on climate change. Tesla’s strong performance reflects in part the shift in the financial markets’ sentiment away from a carbon-intensive to a lower-carbon future, while the charismatic teenager represents the rise in political power of a generation that will have to live with the consequences of climate change.

So, it is no surprise that central banks and bank regulators in major countries have started to pay attention to the financial consequences of climate change and their impact on the world’s financial systems.  Recent studies by the Federal Reserve Bank  (Climate Change and the Fed, 3/25/2019) and the Bank for International Settlements (BIS, The Green Swan: Central Banks and Financial Stability on the Age of Climate Change, January 2020) ) among others carry a stark message: climate change will have significant macroeconomic and financial consequences, and the financial markets, financial institutions and monetary policy-makers better be prepared for these consequences.  Integrating climate change in the financial regulatory framework will be a key component of financial stability.

Twelve years ago, the global financial system faced a major crisis.  Most economists, policymakers and market analysts either did not see the crisis coming or minimized its potential impact. Yet, the crisis was severe, pushing the global economy in a deep recession.  The financial guru Nassim Taleb coined the expression  “Black Swan” to characterize such an event.  A Black Swan event has three characteristics. First, the event is unexpected and rare. In addition, it cannot be modelled by standard probability distributions, but is  “fat tailed”, (i.e. having higher than expected tail probabilities). Second, it is wide-ranging and has an extreme impact. Third, it can only be explained after the fact.

In its report on the impact of climate change, the BIS extends the concept to “Green Swan”, a phenomenon that has the characteristics of a “Black Swan”, with the added characteristic of being tied to irreversible situations.  In effect, the BIS argues (correctly) that the post-crisis fiscal and monetary policies were able to restore somewhat the health of the economy after 2008, but that we will not have the luxury of reversing the situation with climate reversing the situation with the climate change phenomenon.

The impact of climate change on financial stability stems from a set of complex and interrelated factors.

• The direct impact on the global macroeconomy
• The deterioration of credit conditions
• Massive increases in financial losses of communities, businesses and households impacted by climate change
• Impact on asset prices during the transition from a “brown” (carbon-intensive) to a ”green” (low-carbon) economy
• Uncertainty regarding the costs/benefits of climate change mitigation

In addition, financial markets participants will face the fact that climate change risk-assessment is complex: non-linear, far-reaching and subject to tipping points. However, this complexity should not mean that financial regulators and monetary policy-makers should throw in the towel. Quite the contrary.  Faced with existential climate change risks, central banks and financial regulators should urgently take steps to ensure the stability of the global financial system.

According to the BIS report, physical and transition risks to the financial system will manifest themselves through five channels: credit risk, market risk, liquidity risk, operating risk and insurance risk. With this framework in mind, financial regulators should focus on integrating systematic climate change risks in the evaluation and regulation of financial institutions. This would mean developing statistical and economic models for assessing the impact of climate change, modifying credit risk assessment standards, adding climate change risk in stress-testing of financial institutions, and increasing the resilience of the financial systems by boosting capital requirements.

These are first steps in facing the impact of climate change.  Fortunately, we are seeing movement in this regard by the major central banks and financial regulators.  However, we must recognize that mitigating the economic and financial impact of climate change needs a holistic  and global approach.  Davos indicated that we are going beyond lip-service in the international financial and business community, and Greta underscored the emerging global political determination to move forward.