by Judith Curry
Too rapid a movement towards a low-carbon economy could materially damage financial stability: a climate Minsky moment — Mark Carney
A recent speech given by Mark Carney, Governor of the Bank of England, entitled Resolving the Climate Paradox. The whole text of the speech is well worth reading, here I focus on excerpts related to the idea of the ‘tragedy of the horizon.’ Excerpts:
When I spoke at Lloyd’s of London a year ago about the financial stability risks arising from climate change, I, in effect, highlighted two paradoxes.
1 First, the future will be past. That is, climate change is a tragedy of the horizon which imposes a cost on future generations that the current one has no direct incentive to fix. The catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors including businesses and central banks. Once climate change becomes a clear and present danger to financial stability it may already be too late to stabilise the atmosphere at two degrees.
2 The second paradox is that success is failure. That is, too rapid a movement towards a low-carbon economy could materially damage financial stability. A wholesale reassessment of prospects, as climate-related risks are re-evaluated, could destabilise markets, spark a pro-cyclical crystallisation of losses and lead to a persistent tightening of financial conditions: a climate Minsky moment.
The final and most important channel involves transition risks, which could result from the 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 but 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.
Tonight, I would like to discuss how building new markets – in climate transition and green finance – can help resolve the tragedy of the horizon. Over the past year, the focus of G20 Leaders and the aegis of the FSB have spurred important progress. The upcoming German presidency of the G20 now has a historic chance to mainstream climate finance and turn risk into opportunity.
Clear policy frameworks that encourage sustained private investment are thus essential, including those that mobilise private investment to finance the transition to the low-carbon economy. As I will discuss, the magnitudes required are significant, the horizons long, and the distribution Pareto improving.
Therefore, Paris clarifies actual and stretch objectives. It provides detailed climate policies and creates the prospect of a future ratcheting up of efforts. In doing so, it greatly increases transition risks as well as opportunities. By bringing forward the horizon, it puts a premium on the ability of private markets to adjust.
Smooth adjustment is crucial because transition risks are how success could turn into failure. Specifically, sudden changes in policy, technology and physical risks could prompt a reassessment of asset values as costs and opportunities become apparent. In other words, an abrupt resolution of the tragedy of horizons is in itself a financial stability risk.
The point is that the more we invest with foresight; the less we will regret in hindsight. Financial stability risks will be minimised if the transition begins early and follows a predictable path, thereby helping the market anticipate the transition to a two-degree world. And that requires the right information. On this front, there has also been considerable progress in a short period of time.
Markets that value the future
Financial policymakers will not drive the transition to a low-carbon economy. Governments will establish the frameworks, and the private sector will make the investments.
Nonetheless, financial policymakers do have a clear interest in ensuring the financial system is resilient to any transition hastened by those decisions. Our role is to help develop the frameworks for markets to adjust efficiently.
Given the uncertainties around climate, not everyone will agree on the timing or scale of adjustment required. The right information allows sceptics and evangelists alike to back their convictions with their capital.
A market in the transition to a two-degree world can be built. 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. It will help smooth price adjustments as opinions change, rather than concentrating them at a single climate “Minsky moment”.
And it would allow feedback between the market and policymaking, making climate policy a bit more like monetary policy, with policymakers learning from markets’ reactions, and markets internalising policymakers’ objectives, strategies and instruments. When rates are low, the present value of future returns and risks are greater.
That is why a vocal minority are already calling on businesses to invest for the future, including by supporting the transition to a low carbon economy, and for investors to internalise the risks and opportunities of climate change. 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. By managing what gets measured, and building a mainstream green bond market, we can help resolve the Tragedy of the Horizon.
JC reflections
A transition away from fossil fuels by the end of the 21st century is not unlikely, independently of a climate change driver. The key issue is whether and how fast climate change should drive the transition away from fossil fuels.
Carney makes important points about the Tragedy of the Horizon and also transition risks. A Minsky moment is a very real and substantial concern regarding rapid emissions reductions. He proposes that that a green bond market, combined with better information, can help manage the Tragedy of the Horizon as well as transition risks. This proposal sounds much more appealing to the broad political spectrum than regulations and taxes.
I find this point to be key:
Given the uncertainties around climate, not everyone will agree on the timing or scale of adjustment required. The right information allows sceptics and evangelists alike to back their convictions with their capital.Filed under: Policy