The Green Swan – Central Banking and Financial Stability in the Age of Climate Change

After completing this reading, you should be able to:

• Describe the concept of “green swan,” how it differs from “black swan,” and why climate change is considered a ”green swan” event. 
• Explain why climate change is a threat to price stability. 
• Explain why climate change is a threat to financial stability by describing the ways physical and transition risks can materialize. 
• Discuss the measures that should be considered by members of the financial safety net under the risk, time horizon, and system resilience approach, as well as the limitations of these measures.

Green-Swan vs. Black Swan Events

Green Swan

A green swan refers to an unexpected environmental catastrophe attributed to climate change. It is a large-scale, high-impact event connected with global warming and the impacts of pollution that could trigger a systematic financial crisis with worldwide implications. Green swans are risks created by human behavior. That includes pumping pollutants into the environment, destroying natural ecosystems such as forests and water catchment areas, and destabilizing climates. 

Analysts in both environmental and business issues argue that in years to come, unprecedented environmental crises “green swans” could pose an existential threat to humans. It’s not just the financial ecosystem that’s at stake: a green swan poses grave danger to all forms of life on the planet.

Black Swan

A black swan event is one that:

• Comes as a surprise and lies in the outer realm of regular expectations;
• Is associated with extremely high impact; and
• Can only be explained after the fact, i.e., rational analysis is only possible after the event has occurred.

Black swan events can take many forms: It could either be a disruptive technology, terrorist attack, or a natural disaster. What’s more, black swan events do not follow the normal distribution. Rather, they tend to fit fat- tailed distributions, indicating an increased probability of extreme, high-impact occurrences. 
The implication of this is that it’s almost impossible to try to model and predict black swan events using backward-looking probability approaches as most of them are usually built around the assumption of normality.

Black swans can be hedged against by acknowledging the risk of uncertainty, and therefore investing in understanding precise patterns underlying identified in complex systems. This makes it possible to identify any variations and appropriate measures enacted to prevent extreme risks. Black swans can also be hedged against by using counterfactual reasoning, where thoughts about alternatives to past events are used to hedge against extreme risks. This approach turns black swans into ‘’grey swans’ but does not necessarily essentially make them disappear. 

How Green Swans Are Different from Black Swans

Although green swans share many similarities with black swans, there are notable differences:

• Whereas black swan events are totally unpredictable and unexpected, green swan events can, to an extent, be anticipated. In other words, there are tell-tale signs that green swan events will occur some time in the future. This suggests that certain preventative/mitigatory measures could be taken now even though there’s great uncertainty as to when exactly the events will occur.
• Although black swan events can be hugely destructive, they stop short of an existential threat to life. Green swans, on the other hand, have the potential to obliterate human life as we know it. 
• Whereas black swan events are complex and difficult to analyze and predict, green swan events are even more complex and extremely difficult to model. Green swan events are associated with complex chain reactions, and there’s simply no telling as to how exactly they will disrupt environmental, geopolitical, and economic systems.

It’s for these reasons that climate change is categorized as a green swan event. We already know that there will be consequences for the destructive human behavior witnessed hitherto, but we simply cannot predict how tough things will get.

Why Climate Change is a Threat to Price Stability

Extreme weather events such as heatwaves, storms, or floods, are referred to as physical risks and can directly affect prices and the real economy in the following ways:

• An increase in the rate of inflation, for instance, food prices tend to increase in the short-term following natural disasters and extreme weather.
• A decline in growth and productivity as a result of natural catastrophes. Such that, natural catastrophes may result in growth and productivity declines due to the loss of physical capital, supply chain interruptions, and reduced labour supply, leading to price instability. Such supply shocks carry the risk of inflation and output developing in opposite directions, which makes economic stabilization more difficult.
• Extreme weather events can negatively affect consumption and result in a situation where households are no longer keen to acquire goods and services. This could happen because such extreme events could destroy physical assets and disrupt supply lines. In the aftermath of a severe climatic event, households and individuals may show a greater propensity to save. This would reduce demand and therefore a shift in prices; hence, influencing price stability.

Why Climate Change is a Threat to Financial Stability

There are two main channels through which climate change can impact financial stability:

1. Physical risk

Physical risks refer to financial losses and economic costs that arise due to an increase in the frequency and severity of climate-related weather events. That includes floods, heat waves, and storms. Physical risk also includes losses attributable to long-term changes in climatic patterns. Such long-term changes include acidification of oceans and rising sea levels. For example, rising sea levels may affect real estate plans along the much-loved coastline. This would in turn affect the financial position of real estate investment trusts, i.e., REITs.

Here’s a breakdown of the exact ways through which physical risk can result in financial instability:

• Reallocation of household financial wealth: For instance, rising sea levels along the coastline can negatively impact the prices of real estate assets in the region. This would directly impact the wealth of people who have already invested in the area, who may have to look for alternative investments.
• Change in risk preferences: Climate-related physical risks can impact the expectation of future losses, consequently affecting current risk preferences. For example, real estate investors will tend to avoid property exposed to the risk of sea-level rise. Such properties will sell at a significant discount relative to other similar properties that are currently not exposed to the risk of rising sea levels.
• Increased risk of insolvency: Losses suffered from the occurrence of climate-related events have the potential to threaten the financial stability of not just businesses but also individuals and governments. This is especially true with regard to uninsurable events.
• Increased pressure on the insurance sector: As claims for damages increase in the aftermath of natural disasters, insurance may contend with huge payouts that may by far surpass their reserves. This could put them in a fragile financial situation.
• Increased pace of capital depreciation: Damages to assets as a result of overly harsh weather impacts the longevity of physical capital by increasing the speed of capital depreciation.

2. Transition Risk

Transition risks refer to the uncertain financial implications that could be brought by a rapid low-carbon transition. This includes reputational implications, policy changes, technological limitations or successes, and shifts in social norms and market preferences. Transition risks affect financial stability in the following ways:

• Development of stranded assets: If policies are enacted to reduce carbon emission and implemented successfully, it means there will be “stranded” assets that will suddenly become worthless. This can pose a serious threat to the stability of the financial system. If these assets are subjected to a fire sale, they will end up being traded at extremely discounted prices, a situation that could potentially trigger a financial crisis.
• Some will be hit more than others: Sectors/industries that directly rely on fossil fuel will be impacted more than other sectors. For example, the automobile industry will be among the most hit, and we may see huge price swings as new technologies are unveiled, and individual preferences change.

Ways Physical Risk and Transitional Risk can Materialize

Physical and transition risks can materialize in terms of financial risk in five main ways: 

• Credit risk: Through direct or indirect exposure, climate-related risks can lead to the decrease of a borrower’s ability to repay their loans, thus, increasing the probability of default as well as the loss-given-default (LGD).
• Market risk: A rapid transition scenario could render a significant amount of assets “stranded”, a situation that could change investors’ perceptions about the profitability of such assets. A huge loss in the market value of such assets could be devastating to the economy and possibly trigger a financial crisis.
• Insurance risk: For the insurance and reinsurance sectors, physical risk can increase insurance claim payouts to a higher-than-expected level. On the other hand, transition risks could lead to a potential underpricing of new insurance products covering green technologies.
• Operational risk: Financial institutions can be impacted through their direct exposure to climate-related risks. For example, a bank’s operational procedures could be affected if its offices or data centers are impacted by physical risks, consequently affecting other institutions across its value chain.
• Liquidity risk: Banks hit hard by credit and market risks could find it difficult to refinance themselves in the short-term.

Policy Responses that Should be Considered by Members of the Financial Safety Net

Climate Risk Approaches

Measures to be Considered by Central Banks Supervisors and Regulators

• Climate-related risks should be included in prudential guidelines that dictate how much capital should be set aside as a way of recognizing various risk exposures. 
• When monitoring the financial stability of an institution, regulators and central banks should also assess the institution’s policy towards climate-related risks.

Measures to be Implemented by Other Players, e.g., Government, Civil Society, and the Private Sector

• There should be voluntary disclosure of climate-related risks by the private sector.

Limitations

• Climate-related risks will remain impossible to hedge in the absence of a system-wide transformation.
• Measuring climate-related risks remains a challenge, particularly due to the application of a non-consistent probabilistic tool at the macroeconomic, sectoral, and inter-sectoral levels.

Time Horizon Approaches

Measures to be Considered by Central Banks Supervisors and Regulators:

Promotion of long-term rationale as a method to break the tragedy of the time horizon by: 

• Exploring the potential implications of sustainable approaches in the conduct of financial stability policies, when considered as consistent with the existing mandates.
• Inculcating environmental, social, and corporate governance (ESG) into central banks’ portfolios.

Measures to be Implemented by Other Players

• Implementing carbon pricing as a market-based strategy for lowering global warming emissions. Carbon pricing is a scientific tool used to measure the costs of gas emissions that humans are forced to pay. Such costs include damage to property and agricultural resources and healthcare costs.
• Systematization of environmental, social, and corporate governance (ESG) practices in the private sector.

Limitations

• If central banks go it alone and take isolated actions, their efforts would not be sufficient to reallocate capital at the pace required, and this could cause unintended implications.
• Although carbon pricing can be an effective tool as a measure of the overall cost of gas emissions, it also has its limits. In particular, it doesn’t take into account the damage that’s already been done. 

System Resilience Approach

Measures to be Considered By Central Banks, Supervisors, and Regulators

Recognizing the need to acknowledge the deep uncertainty about the future of climate matters and the survival of the human race, as well as the need for structural transformations to preserve long-term climate and financial stability. Some of the actions that could be explored include:

• Promoting “green” monetary as well as fiscal regulations.
• Using qualitative approaches and non-equilibrium models to better express the complex and uncertain interconnection between climate and socio-economic systems.
• Reforming the international monetary and financial system to recognize climate risks and consider climate and financial stability as public goods that should be protected at all costs.

Measures to be Implemented by Other Players

• Integrating natural capital into national and corporate accounting systems.
• Enabling or facilitating green fiscal policy by low-interest rates.
• Integrating climate stability as a public interest.

Practice Question

Which of the following statements is correct about black swans?

  A. Black swans are unexpected environmental catastrophes attributed to climate change

  B. Black swans can also be hedged against by using counterfactual reasoning

  C. Black swans are events that are easily seen and predicted

  D. None of the above

Solution

The correct answer is B.

Black swans can be hedged against by acknowledging the risk of uncertainty, but they can also be hedged against by using counterfactual reasoning, where thoughts about alternatives to past events are used to hedge against extreme risks

A is incorrect: A green swan refers to an unexpected environmental catastrophe attributed to climate change.

C is incorrect: Black swans are often rationalized as events that could have been foreseen had the facts been carefully examined. However, we characterize black swans are unpredicted by the mass.