The risks associated with climate change, biodiversity loss, and our responses to those problems are poorly understood, because there are no historical comparisons. But with the right tools, central banks and other macro-prudential authorities can stay ahead of the curve.

The statistician Nassim Nicholas Taleb coined the term “black swan” to describe improbable, hard-to-predict events that can have a massive impact on the economy. The authors of a recent report have now introduced into the taxonomy of finance the phrase “green swans”: events caused by climate change and biodiversity loss.

The appearance of green swans is arguably more predictable than that of black swans, as climate change makes them unavoidable. But there are no historical comparisons to help us understand how climate and ecological risks such as cyclones, wildfires, droughts, and floods might affect the banking system, the insurance industry, or any number of other economic activities.

As economic activity is reallocated from fossil fuels to clean energy sources, some activities will disappear, others will emerge, and the value of “stranded assets” will plummet. Although this process is necessary, it must be managed in a way that does not create instability in the financial system.

Owing to their financial-stability mandate, central banks, supervisors, and macro-prudential authorities have a central role to play in the green transition. The recent Green Swan Conference organized by the Bank for International Settlements, the Banque de France, the International Monetary Fund, and the NGFS (Network of Central Banks and Supervisors for Greening the Financial System) points to a growing recognition of this fact, though the mobilization remains too slow and too timid in some geographic areas.

With an eye toward anticipating the effects of climate risk, the Banque de France was the first central bank to introduce a comprehensive climate stress test for banks and insurance companies. Analyzing three 30-year climate scenarios devised by the NGFS (an orderly transition based on a low-carbon strategy; a disorderly, late transition; and a business-as-usual scenario), the test sought to assess banking and insurance portfolios’ exposure to both physical and transition risks.

This exercise showed that the French system’s current exposure is only moderate (under the assumptions used). More important, the climate stress test demonstrated what it will take to improve our understanding of climate risk.

There is much more work to do. For example, we still lack databases detailing the geographical conditions throughout global value chains. This information is essential to assess physical risks to production, and it would also be useful for monitoring social and environmental governance issues more broadly.

The increased frequency and severity of weather-related disasters will gradually come to be reflected in insurance coverage and costs, affecting profitability and the default rates of loan portfolios in the banking sector. At the same time, bankers and asset managers will be adjusting their portfolios accordingly. And if the price of carbon continues to rise, as it should, they will move away from carbon-intensive sectors, increasing their exposure to other risk factors.

These time-varying behaviors (and their knock-on effects) will matter for financial stability; but they are difficult to model. Still, a few essential policies would greatly help macro-prudential authorities and investors manage the change. First, those embarking on the green transition will need a compass: there should be a fully predictable increase in the carbon price across as wide an economic area as possible. The European Union could be on the right track here with its Emissions Trading System, wherein the price of carbon has risen from €25 ($30) per ton in January 2020 to €50 per ton today. But progress remains limited, because the ETS covers only about 40% of EU emissions.

As a recent G30 report shows, credible commitments to deliver a predictably increasing carbon price are needed to enable investors, regulators, and monetary policymakers to adjust their strategies in a forward-looking manner. In their absence, we will be unable to unleash public and private investment in the structural adjustments needed to reduce the costs of the broader transition.

To achieve this, independent carbon councils can manage carbon-price inflation in a similar manner to how central banks manage inflation affecting the prices of goods. These institutions should have a mandate to map out a carbon-price-inflation path aligned with their respective governments’ 2050 net-zero objectives. These policies must be accompanied by compensation of those most affected by a decline in purchasing power, owing, for example, to an increase in fuel prices.

Capital requirements for financial institutions could be linked to their exposure to a rising carbon price, which would change their calculated probability of defaults and losses on their portfolio. Supervisors also will need to ensure that financial institutions establish effective governance systems to deal with climate risk. Unlike what happened with shadow banks, whose growth reflected an ability to circumvent stricter banking regulations, we should endeavor to track “shadow emitters” very closely. The US Environmental Protection Agency recently revealed that five of the top ten methane emitters in the United States are little-known oil and gas producers, backed by little-known investment firms.

We should expect that private equity firms will try to acquire risky oil and gas properties, develop them, and sell them at a profit. But we cannot tolerate “below-the-radar” investors buying up carbon-intensive assets at fire-sale prices and then operating them in lax jurisdictions. Preventing this will require a high global floor on carbon prices, carbon border adjustment taxes, or both. The cost of capital for such investments must become prohibitively high, even if it means adjusting the regulatory perimeter.

A final key climate-policy component is mandatory disclosures of CO2 emissions and a framework for harmonizing those disclosures globally in order to enforce universal minimum standards. This idea is already gaining momentum and may become more concrete after the United Nations climate summit (COP26) in November. Transparency is crucial for all market participants. It is incumbent on the institutions in charge of financial stability to ensure that green swans do not turn black.

Hélène Rey is Professor of Economics at the London Business School and a member of the Haut Conseil de Stabilité Financière.

Read the original article on project-syndicate.org.

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