Jon Shapley/Houston Chronicle via AP
A truck drives through a flooded highway in southeast Texas, September 20, 2019.
Every few months, a news outlet will write a story heralding the next financial crisis, with an assumed assuredness that we should all view as suspect. Predicting the next crisis has become a sport, one that typically magnifies risks and displays an unreasonable degree of certainty. But if you had to choose a looming event that’s most likely to produce a negative shock to the financial system, it would almost certainly be the climate emergency.
That’s the takeaway from a fascinating issue brief out today from the Center for American Progress’s Gregg Gelzinis and Graham Steele from the Stanford Graduate School of Business. Both worked for the Senate Banking Committee for many years, and they make a compelling case, not only that headline risks to financial stability will flow from a warming planet and the efforts to mitigate that, but that federal banking regulators have gone almost completely AWOL in monitoring or even assessing this legitimate threat.
Worse, to the extent that any financial regulators in Washington are paying attention to the climate crisis, they’re seeking to dismiss it. A subcommittee formed at the Commodity Futures Trading Commission (CFTC) to look at climate-related market risk is stacked with fossil fuel industry representatives, including several executives from climate-polluting agribusiness, banks with significant carbon-intensive portfolios, and fossil fuel giants BP and ConocoPhillips.
The committee’s clear intent is to examine the climate risks to polluting companies’ core business, not from their polluting. As one critic—Paddy McCully, the climate and energy director at the Rainforest Action Network—notes, “We should recognize that there’s risk from the climate to the economy, and that the corporate sector needs to assess their contributions to climate change and then deal with it.”
The report explains that global economic losses from a rise in temperatures of 4 degrees Celsius have been estimated at $23 trillion per year. This would pose two kinds of risk to the financial system: physical risk from natural disasters, and a more indirect risks from transitioning away from fossil fuels.
The physical risk is somewhat obvious: Climate change–induced extreme weather events (hurricanes, fires, flooding, etc.) can stress insured assets along coastlines, from mortgaged homes and commercial real estate, to small businesses and farms that borrow money. This is particularly threatening to insurers. Gelzinis and Steele use the example of Hurricane Andrew, the 1992 storm that hit south Florida with unexpected force. At least 16 insurance companies failed after Andrew because they didn’t anticipate the magnitude of the damage. “In the early 90s, insurers really weren’t using catastrophe-risk modeling as we know it today,” says Gelzinis, who was a staffer for Senator Jack Reed (D-RI) before joining CAP. “When you hear about risk modeling today not predicting things, you start to feel a little vulnerable.”
Today insurance companies average $50 billion in natural disaster–related claims every year. Today, these companies are far more interconnected and systemically significant than in times past. Even if insurers cut their losses and pull out of climate-threatened areas, the resulting economic collapse would threaten bank-held assets. Alternatively, a bankrupt insurer could liquidate assets in a fire sale to pay creditors, lowering the value of those assets across the board. And a failure from accumulated losses of an extreme weather event at a major insurer would cascade through the financial system, through the investments of partners and creditors. That resembles the scenario in which AIG got wiped out in the subprime mortgage crash, threatening its counter-parties who sought to call in credit default swaps.
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In this sense, the financial system is just as fragile as properties destroyed by natural disasters, because of its deep interconnections, where losses can ripple out to other players. “Correlated risk can stress the financial system, and have spillover effects to the real economy,” says Gelzinis.
The second-order risk, paradoxically, results from the potential success of getting the political system to act on climate. If Congress supports a firm transition away from fossil fuels, or if a technological advance makes renewables radically cheaper and easily deployable, financial firms, insurers, and investors with carbon-sensitive assets could abruptly be stuck with worthless investments.
These numbers are significant. The six largest banks in America financed fossil fuel–related businesses to the tune of $700 billion from just 2016 to 2018, according to the Rainforest Action Network. Columbia professor Adam Tooze estimates that of the total equity and fixed income assets in the world, as much as one-third are carbon-sensitive, and investors have increased their holdings in these assets significantly over the past three years. Gelzinis and Steele cite one study putting losses from the value of carbon-sensitive assets at $18 trillion.
That there aren’t hard numbers on all this—only estimates—is part of the problem. “It shows how far behind we are,” Gelzinis says. One of the paper’s recommendations is to direct the Treasury Department’s Office of Financial Research to analyze these risks in more detail.
But even with estimates, we’re talking about an event larger than the subprime meltdown. If carbon prices evaporate, who takes the losses? Would fire sales ensue? Would animal spirits take over markets as soon as the signal is clear that fossil fuels are on the way out? There are ways to gradually manage and price in this risk over time, but at the moment, U.S. bank regulators are doing nothing about it, when they’re not being actively harmful.
Federal Reserve Chair Jerome Powell has begged off any responsibility for the climate crisis, calling it “a responsibility that Congress has entrusted to other agencies.” The San Francisco Federal Reserve has published some papers by outside experts about climate change and financial stability, but one regional central bank (unsurprisingly located on a coastline and lately, in a fire zone) is no substitute for actual federal action. The Fed has not even joined the Network for Greening the Financial System, a coalition of 48 nations’ central banks studying how best to transition away from the fossil fuel economy. For such a major systemic risk, the lack of interest is staggering. “This is squarely within the Fed and other regulators’ mandate,” Gelzinis says. “Without a strong push, financial firms won’t move enough on their own at a quick enough pace.”
If anything’s worse than doing nothing, it’s the CFTC’s climate subcommittee. JPMorgan Chase, by far the largest financier of fossil fuel companies, has a seat on the subcommittee. So does Citigroup, the third-largest financier. Morgan Stanley, which is heavily involved with crude oil and jet fuel through its commodities business, has a seat. Goldman Sachs, which operates its own coal mines and trades in uranium, arguably has two seats: one for itself, and the other for Stephen Moch, listed by CFTC as a “student” with the Harvard Business School and Kennedy School of Government but actually a senior analyst with Goldman’s Environmental Markets Group for four years. French bank BNP Paribas, German investment firm Allianz and several other financial players hold seats as well.
BP and ConocoPhillips each have members on the subcommittee, too, as do Bunge and Cargill, two major agribusiness and trading companies that have been complicit in the burning of the Amazon rainforest. “Amazon Watch research shows that both Bunge and Cargill purchased soy and other grains in Brazil produced with illegal deforestation,” says Christian Poirier, Amazon Watch's program director. “As we saw so viscerally this summer with the Amazon fires, deforestation in the Amazon has drastic consequences for the climate given the rainforest's key role in storing carbon and regulating weather patterns across the hemisphere."
If these are the sources that federal regulators use to “assess” climate risk, it may be better for them to not assess it at all. Obviously, a report written by banks and polluters will focus on how they can avoid financial loss from climate transformation, not how the planet can survive and heal. And they certainly wouldn’t recommend divestment or anything harmful to their bottom lines in the near term.
The report from Steele and Gelzinis calls for a strong regulatory response to climate-induced financial risk, most of which could be done without new legislation. Joining the Network for Greening the Financial System would be the bare minimum. The Securities and Exchange Commission could require public companies to detail their own financial risks from the climate crisis. Regulators could add climate change to their stress tests of the financial system, examining the impacts of a large hurricane or drastic drop in the value of carbon-related assets. They could even supervise financial companies for climate preparedness and force companies with higher carbon-sensitive assets to carry more capital to absorb losses.
If Democrats take the White House in 2020, Gelzinis believes banking regulator stances on climate issues will have to take center stage. “It’s something we have to hold nominees to when selecting who will be at the financial regulatory agencies,” he says. “To the extent that minority-party commissioners can raise the specter of this issue [today], it helps pave the way for action later, so it’s not an argument we’re making for the first time in January 2021.”
As for now, our financial system seems to be whistling past a climate graveyard. Financial firms are so deeply implicated in fossil fuels that any disruption—a physical one or a financial shock that re-prices carbon assets—will cause widespread suffering and potential catastrophe. And these risks could manifest at any time. Financial regulators can play a signature role in protecting the planet, just by doing their job of preventing systemic risk.
