The mistake of climate finance risk by John H. Cochrane

The idea that climate change poses a threat to the financial system is absurd, not least because everyone already knows that global warming is happening and fossil fuels are disappearing. The new push for climate-related financial regulation is not really about risk; it is a political agenda.

STANFORD – In the United States, the Federal Reserve, the Securities and Exchange Commission and the Treasury Department are preparing to integrate climate policy into American financial regulation, after even bolder measures in Europe. The rationale is that “climate risk” poses a danger to the financial system. But this statement is absurd. Financial regulation is used to smuggle climate policies that would otherwise be dismissed as unpopular or ineffective.

“Climate” refers to the probability distribution of weather – the range of potential weather conditions and events, along with their associated probabilities. “Risk” means the unexpected, not changes that everyone knows are happening. And “systemic financial risk” means the possibility of the whole financial system collapsing, as it almost happened in 2008. It does not mean that someone somewhere could lose money because of the failure. fall in the price of certain assets, although central bankers are rapidly expanding their scope in this area. direction.

Clearly, then, a “climate risk to the financial system” means a sudden, unexpected, large and widespread change in the distribution of the probabilities of time, sufficient to cause losses that spill over into equity and debt buffers. long term, causing a system-wide race on short-term debt. This is the horizon of five or ten years at most over which regulators can begin to assess risks on the balance sheets of financial institutions. Loans for 2100 have not yet been granted.

Such an event is outside any climate science. Hurricanes, heat waves, droughts and fires have never failed to cause systemic financial crises, and there is no scientifically validated possibility that their frequency and severity will change so drastically to alter this fact over the years. next ten years. Our modern, diverse, industrialized and service-oriented economy is unaffected by weather conditions, even by the events that make the headlines. Businesses and people are still moving from the cold rust belt to hot and hurricane-prone Texas and Florida.

If regulators impartially worry about non-standard risks that put the financial system at risk, the list should include wars, pandemics, cyberattacks, sovereign debt crises, political collapses, and even corporate strikes. asteroids. All but these are more likely than climate risk. And if we’re worried about the costs of flooding and fires, maybe we should stop subsidizing construction and reconstruction in areas prone to flooding and fires.

The climate regulatory risk is slightly more plausible. Environmental regulators could prove to be so incompetent that they hurt the economy to the point of creating a systemic race. But this scenario seems far-fetched to me even. Again, if the issue is regulatory risk, then impartial regulators should demand wider recognition of all political and regulatory risks. Between the new interpretations of antitrust law by the Biden administration, the trade policies of the previous administration, and the pervasive political desire to “break big technology,” there is no shortage of regulatory danger.

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Certainly, it is not impossible that a terrible climate-related event over the next ten years could cause a systemic race, although nothing in current science or economics describes such an event. But if that is the fear, the only logical way to protect the financial system is to dramatically increase the amount of equity, which protects the financial system from any kind of risk. Risk measurement and technocratic regulation of climate investments, by definition, cannot protect against unknown unknowns or unmodeled “tipping points”.

What about “transition risks” and “stranded assets? »Will the oil and coal companies not lose value in the transition to low carbon energy? Indeed, they will. But everyone already knows that. Oil and gas companies will only lose value if the transition occurs faster than expected. And legacy fossil fuel assets are not funded by short-term debt, like mortgages were in 2008, so losses to their shareholders and bondholders do not jeopardize the financial system. “Financial stability” does not mean that no investor ever loses money.

Plus, fossil fuels have always been risky. Oil prices turned negative last year, with no wider financial consequences. Coal and its shareholders have already been hammered by climate regulations, without the slightest trace of financial crisis.

More broadly, in the history of technological transitions, financial problems have never come from declining industries. The stock market crash of 2000 was not caused by losses in the typewriter, film, telegraph and slide rule industries. It’s the tech companies that are slightly ahead of their time that have gone bankrupt. Likewise, the stock market crash of 1929 was not caused by the drop in demand for horse-drawn carriages. It was the new industries of radio, film, automotive and household appliances that collapsed.

If one is worried about the financial risks associated with the energy transition, the new astronomically valued darlings like Tesla are the danger. The greatest financial danger is a green bubble, fueled like previous booms by government subsidies and encouragement from central banks. Today’s high-flying people are vulnerable to changing political whims and new and better technologies. If regulatory credits dry up or if hydrogen fuel cells replace batteries, Tesla is in trouble. Yet our regulators only want to encourage investors to rush in.

Climate financial regulation is an answer to the search for a question. It is about imposing a specific set of policies that cannot pass through regular democratic legislation or regular environmental regulation, which requires at least some semblance of cost-benefit analysis.

These policies include financing fossil fuels before the replacements are put in place and subsidizing electric cars, trains, wind turbines and battery-powered photovoltaics – but not nuclear, carbon capture, hydrogen, gas. natural, geoengineering or other promising technologies. But, because financial regulators are not allowed to decide where to invest and what should be deprived of funds, the “climate risk to the financial system” is imagined and repeated until people believe it, in order to transpose these climate policies in financial regulators. ‘limited legal mandates.

Climate change and financial stability are urgent problems. They require coherent, intelligent, scientifically valid and swift policy responses. But climate financial regulation will not help the climate, further politicize central banks and destroy their precious independence, while forcing financial firms to design absurdly fictitious assessments of climate risks will ruin financial regulation. The next crisis will come from another source. And our climate-obsessed regulators will once again fail to anticipate it – just as a decade of stress testers never considered the possibility of a pandemic.

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Paul Cox

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