Why 2 Degrees Celsius May Beat 2 Percent CPI

Investors should watch closely as some financial regulators begin to take a more expansive view of their mandates and pay more attention to the planet's rising temperature.

Noted American Economist and Nobel Prize Winner Joseph Stiglitz argues that climate change is a crisis that warrants the kind of policy response that was last employed during World War II. The policy cost should be viewed as irrelevant when compared to the consequences of inaction. Extreme climate domino effects could lead to water scarcity crises and threats to food production systems – events that could potentially tip nations in some hard-hit regions into military conflict.

Under such extreme scenarios, the traditional central banker’s focus on a 2% CPI forecast might become meaningless. The 2 degrees Celsius target - the threshold an increase in the average global temperature is believed to yield catastrophic results if crossed - might become a target that overwhelms all others.

Some might argue that the long-run consequences of climate change may occur beyond the usual policy forecast horizon for central banks. However, the San Francisco Fed indicated that central banks already consider long-term factors such as demographic change when formulating policy. They argue that climate change is becoming relevant for a range of macroeconomic issues, including potential output growth, capital formation, productivity, and the long-run level of the real interest rate. 

The same paper identifies climate change as one of the three key macro forces that will shape the U.S. economy in the 21st century (along with demographics and technological innovation). The authors describe how climate change will have direct effects on the economy via adaptation spending to accommodate rising temperatures including more air conditioning, better flood defense spending and more resilient infrastructure. In addition, they highlight transition risks associated with the adjustment to a low-carbon economy as fossil fuel assets risk including the possibility of large fossil fuel assets becoming stranded as demand for oil and gas declines.

The San Francisco Fed paper argues that climate change is relevant for the formulation of the Federal Reserve’s monetary and regulatory policy by highlighting the risk of loan losses for banks that result from business interruptions and bankruptcies caused by extreme weather events. Financial institutions should conduct “climate stress tests” to assess their solvency across a range of future scenarios instituted by environmental and ecological change, the paper concludes. 

The Bank of England has gone further, suggesting that stress tests should provide a framework against which banks and insurance companies can be challenged to explain how they are managing environmental risk. Financial firms will also need to respond to these stress tests and detail emergency response planning. Senior bank staff have cautioned that, although wider policy should be set by government, cleaning up after a climate-related emergency will undoubtedly involve the Bank of England.

Member of the Executive Board of the European Central Bank Benoit Coeure in a speech late last year highlighted the ways climate-related risks could affect the economy through elevated credit spreads, increased precautionary saving, and even a future financial crisis. He questioned who will be held responsible for paying for the consequences of extreme weather, such as agricultural losses, the effect of commodity price spikes, flood damage, etc. If the carbon emitter is going to pay, how does one calculate the charge when the impact has an infinite horizon? 

Moreover, consider that the largest emitters (to date) have been developed economies. Yet many coastal cities that are most vulnerable to sea level increases are in the emerging world. How should emitters compensate those who are impacted in other nations? 

It has been only four years since Bank of England Governor Mark Carney made his landmark speech on climate change and was subsequently accused of mission creep. Things have moved quickly. There were 21 speeches by Central Bank officials that covered the topic in the 12 months leading up to March 2019. All but two of those were by members of the Network for Greening the Financial System (NGFS), a central bank club launched in late 2017 as a “coalition of the willing” after a G20 sustainable finance group faltered under U.S. government antipathy. The NGFS launched with eight founding members; it now has 36 members and 6 observers.

Do existing central bank mandates incorporate a climate change goal? Research from the University of London has examined the directives of over 100 Central Banks and found that 16 explicitly mentioned a sustainability target. However, an additional 38 central banks were found to have mandates which described a requirement to support national policy. The University of London’s team argues that where governments have signed the Paris Agreement (and 189 nations have done so) the local central bank has a de facto mandate to support policies that address climate change. 

Just how central banks will ultimately incorporate concerns about climate change into their mandates remains to be seen.  But investors in general, and the financial services industry in particular, should watch closely as some financial regulators begin to take a more expansive view of their mandates and pay more attention to the planet's rising temperature. 

By Gary Smith