Green Swan 2: Climate Change and Global Risks after Covid19

Green Swan 2: Climate Change and Global Risks after Covid19 OECD Presentation The Chief Economist Talks series April 23, 2020 Luiz Awazu PEREIRA DA SILVA(*)

(*) Deputy-General Manager at the Bank for International Settlements. The view expressed here are my own and my coauthors and do not necessarily represent those of the BIS and other institutions.

Patrick BOLTON Morgan DESPRES Luiz Awazu PEREIRA DA SILVA Frédéric SAMAMA Romain SVARTZMAN

Key messages and structure of presentation  From a Black Swan to a « Green Swan ». Why? Climate-related risks behind events that cause large uninsured damages, threat to financial stability

 Mis-priced Climate Risks - forward-looking scenario-based risk management is necessary but not sufficient: To prevent Green Swans requires changes in models, mindset, carbon pricing, many actions by many agents (Central Banks, Governments, civil society, private sector, etc) Central banks financial stability mandate important role but no single actor has silver bullet

 Call for a new landscape of cooperation among players, including but not limited to central banks  Some additional thoughts on global negative externalities (global risks): Is Covid19 like a Green Swan? Are our socio-economic organisations prepared? (for Climate risks as well as for pandemics)?

Like for climate-related risks, the effects of pandemics illustrate trade-off efficiency vs. resilience 2

1. “A climate emergency”, climate-related global risks “We, along with more than 11,000 scientist signatories from around the world, clearly and unequivocally agree that planet Earth is facing a climate emergency” (Ripple et al. 2019)

Impacts of climate change (IPCC 2018) include: ● Extreme temperatures ● Sea level rise ● Impacts on ecosystems ● Ocean acidification

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Multiple risks for the economy and human societies: ● Food and water security ● Inequality ● Conflicts and migrations ● Material losses Number of days per year above a deadly threshold by the end of the ● Threat of extinction century in different climate scenarios. Source: Mora et al. (2017)

2. Climate change as a source of financial instability Growing awareness among central bankers, financial supervisors and regulators that climate change brings systemic risks that will impact financial stability: ● Mark Carney (2015): “once climate change becomes a defining issue for financial stability, it may already be too late” ● Creation of the NGFS (Network for Greening the Financial System) in 2017: “Climate-related risks are a source of financial risk. It is therefore within the mandates of central banks and supervisors to ensure the financial system is resilient to these risks” (NGFS 2018) Catch 22? Physical risks (climate-related accidents) and transition risks (sudden asset repricing)

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Source: Bolton et al. (2020)

Ex: financial instability in oil industry (large drop in prices impact immediately asset value in market cap index) in 2008 and 2020

Sources: Bloomberg

Source: Bloomberg - Standard and Poor's 500 Integrated Oil & Gas Index is a capitalization-weighted index.

3. From Black to Green swans – a first epistemological break ● Black Swans (Nassim Taleb): financial context (i) are tail-risk events (quite unexpected); (ii) have wide-ranging or extreme impacts; (iii) are better explained with analytical tools developed ex post ● Climate-related risks present some of these features… but… ● Climate change backed by science, evidence shows certainty, yet the exact date and impacts of climate change are highly uncertain and nonlinear; extreme disasters cannot be ruled out (Weitzman 2011)  Green Swans ● Backward-looking risk management (e.g. VaR models) cannot model well, quantify these risks  Need for an epistemological break: our minds comfortable with historical, linear, deterministic models; CC different, complex, non-linear; scenario-based forward-looking approaches needed 6

Source: Bolton et al. (2020)

4. Climate-related risks related to radical uncertainty But even scenario-based forward looking risk assessment faces significant methodological challenges related to: ● Inability of macroeconomic-climate models to holistically capture a large range of social, economic and geopolitical chain reactions ● Lack of granularity at the corporate level ● Uncertainty regarding adequate mitigation actions of new technologies Alternative approaches can help: ● Non-equilibrium models (instead of more sophisticated DSGEs with climate modules) ● Sensitivity analysis with more complex scenarios ● Specific country, sector, firm case studies In addition: ● Need to acknowledge radical uncertainty and think in terms of system-wide transition ● Pure risk-based approach might not be sufficient 7

Ex1: Climate-related risks vs. uncertainty – Physical risks Impacts on socioeconomic systems: ● Tipping points ● Nonlinearity, cascading effects… ● Global inequality, migrations, conflicts…

1st Generation IAMs: ● Do not account for tail risks (Weitzman 2011) ● Predicted outcomes and ensuing policy recommendations are “grossly misleading” (Stern 2016) Source: Steffen et al. (2018) 8

Ex 2: Climate-related risks vs. uncertainty – Transition risks Uncertainty v-a-v sector and firm-level exposure to climate related-risks Economic and financial interconnectedness

Source: Campiglio et al (2017) 9

Uncertainty related to technological change The 2100 primary energy mix (in ExaJoules)

Sources: Bolton et al. (2020), based on Carbon Brief (2018) IIASA SSP Database

5. Central banks and coordination, beyond carbon pricing Given complexity of issues, no single agent has a silver bullet;

• Central banks that played a key role during the GFC will not, alone, significantly reduce • •

climate-change related systemic risks CC-related risks create a global negative externality, require adequate pricing of risks, including but not limited to much more aggressive carbon pricing Coordination between various agents is needed, CBs need to play a role, beeing aware that if a climate-related new financial crisis (eg., physical/transition risk) strikes, CBs will find more difficult to fulfil their financial stability mandate

CBs need to contribute to coordination on climate change, within existing financial stability mandate: “without aiming to replace policymakers and other institutions, central banks must also be more proactive in calling for broader and coordinated change, in order to continue fulfilling their own mandates of financial and price stability over longer time horizons than those traditionally considered”.

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5. Other policy responses requiring more coordination Examples (non-exhaustive list), in addition to changes in modeling approaches and re-pricing of CC-related risks using Pigovian tax, etc: With regulators, financial sector: climate-related prudential regulation surely needed, but in what form? How to coordinate with other interventions?

With Governments, development banks: promoting sustainable investments and long-termism: Integrate sustainability factors into central banks’ own portfolios (e.g. Banque de France) With National Treasuries: policy mix, including green fiscal policy; “the fact that central banks in advanced economies are globally setting interest rates near or even below zero […] is probably the greatest contribution from central banks” With IFIs: International monetary and financial cooperation; perhaps even new agencies (Bolton et al. 2018) and new funding such as green SDRs With standard-setters: ecological accounting frameworks; disclosure of exposures; new approaches (e.g. natural capital) to account for economy-nature interactions…

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6. Some additional thoughts – does Covid-19 pandemic look like another Green Swan? Some common features with climate risk • The first global negative externality that has created in two months an unprecedented global sudden stop, producing, ironically but logically, a significant reduction of GHG emissions. Heavy human suffering toll, with very negative distributional consequences • Transmission complex, multiple cascading channels, from physical risks in the real economy into potential global financial crisis • Pricing of this global risk: was a sufficient portion of the risks of Covid19 or any pandemic incorporated in the final costs of our global value chains, our airplane tickets, our logistical and physical transportation costs, etc.? Was any insurance cost against pandemic or any small Pigovian tax considered?

• Cost of insurance important issue: illustrates trade-off between risks of pandemic and our super-efficient, just-in-time, zero storage cost systems; our global networks of production and consumption developed very well but without considering or pricing properly this risk.

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Ex: « observed cost »? Covid-19 pandemic triggered a global sudden-stop PMIs at all-time lows Diffusion index

Surge in jobless, short-time workers Millions

Sources: Consensus Economics; Datastream; IHS Markit; national data; BIS calculations.

Millions

Global stocks2 1 Oct 2019 = 100

7. Like for CC trade-off efficiency vs. resilience, several issues • For these global risks (CC-related, pandemics), the question is now how policies treat and perhaps prevent such global negative externalities (Green Swan): • When likelihood of global risk is high or very high (H1N1, SARS, Covids, etc.) or certain (Climate Risks)?

• When multiple non linear-forces interact with each other: simultaneous demand and supply shocks, geopolitical impacts, increase in inequality with unknown consequences, etc.

• When significant number of human lives is at risk (trade-offs with activity)?

• Answer: Rethink the trade-offs Efficiency vs Resilience of our socio-economic systems. Notion of “buffer” or some necessary “redundancy”. All these have a cost. Several issues in terms of:

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A. B. C. D. E.

Institutional arrangements: more coordination locally and globally?

Production and logistics; new phase of globalization?

Macroeconomic policies: how to cope with more debt, more demand for public goods?

Social challenges and distributional effects Type of carbon footprint in the recovery to be engineered

A. Efficiency vs. resilience: institutional arrangements: more coordination locally and globally?

• Covid19 showed fiscal & monetary policy coordination at both local and global levels. Speed of transmission of pandemic, global contagion in successive regions were a factor. But existing national and global frameworks, relations between CBs also helped. Global and regional safety nets (IFIs, regional arrangements) need to be strengthened; new CB-led facilities (swap lines, liquidity provision) have been important. Some questions remain: • Issues of separation and agencies (macro-financial vs other “public health” vulnerabilities?)

• Should agencies / policies that assess macro-financial vulnerabilities also liaise with agencies that measure health vulnerabilities both at local and global levels (eg., more detailed reports on stress tests, on “buffers” and room for manoeuvre)? (Ex: CBs in the NGFS on CC-risks; Treasuries and local CDCs? Review of capacities? Etc.) • Issues of a global safety insurance framework for pandemic risk. Are redundancies inefficient?

• Is it possible/desirable to have more “buffers”, “redundancies”, room for manoeuvre at a local/global levels v-a-v health vulnerabilities and potential pandemics? Ex: Germany?

• How can we design the right agency models (local CDCs and global agencies like the WHO) to deal with global pandemics; procedures to alert, data and information sharing, etc.

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B. Efficiency vs. resilience: production and logistics • Revisiting the geography of globalization. Progress in logistics and lower transportation cost has allowed just-in-time production models with zero stocks; but might also have made our economies more fragile and much less resilient to shocks (no room for interruptions, nature of funding, etc.).

• Perhaps more consideration for the unknown unknowns and plan for more redundancy (insurance, buffers) that would come handy to respond to such old and new global risks • Example of Banks: post-GFC reforms led to resiliency. Stronger "loss absorption capacity“, “liquidity”, etc. in the banking system: built-in redundancy which makes the system more resilient.

• But other example: Corporate structures may have evolved in a more fragile direction: • 50s : more stable environment and corporates were diversified (in terms of activities and objectives); production structures less global • Since the 70s-80s: more unstable environment and corporates have reduced their diversifications and stretched their GVCs (shareholder value maximization?)

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C.+ D. Efficiency vs. resilience: Macroeconomic challenges: how to cope with more debt, more demand for public goods?

Social challenges with distributional effects present and future • Timely and aggressive fiscal & para-fiscal response to Covid19 has created more debt.

• We will have to live in a New New Normal in both AEs and EMEs. • More public debt (D). More demand for public goods (health services) (G).

• Additional challenge is that with more G and more D, it is still difficult to assess growth and output levels (Y). So uncertainty on how to create more redundancy (insurance, buffers) for prevention; where interest rates (inflation) would be?

• Social challenges. Covid19 has important negative distributional effects. Affect low income and poor countries and low income and poor household in rich countries. If also production locations contracts (for safety and cost reasons), large income losses in EMEs. How to address these new challenges with high D and low Y? 17

Efficiency vs. resilience: is a “green” recovery possible? Type of carbon footprint in the recovery to be engineered • Challenges and complexity of a recovery with lower carbon footprint • Vulnerabilities in real and financial sectors will be larger than post GFC • Need to minimize length of contraction • Traditional political economy pressures • Uncertainty about growth parameters (interest rate, risk premia, inflation, (r-g), (r*) given uncertainty about effects of contraction and uncertainty on savings, etc.)

• But there could be also useful lessons to consider (never “waste” a crisis): • Post-GFC used bail-outs granted to incentivize auto industry toward more electric • Teleworking and reduction of trips, lowers carbon footprint of many businesses • New technologies and changes in production-work location will also change GHG emissions • Public programs to enhance research in carbon reduction and absorption • Regional norms in large markets (Europe?) could create market incentives to accelerate adaptation and mitigation to lower carbon economy 18

THANK YOU

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