Green Swan 2: Climate

Change and Global Risks

after Covid19

OECD Presentation
The Chief Economist Talks series
April 23, 2020
Patrick BOLTON
Luiz Awazu PEREIRA DA SILVA(*) Morgan DESPRES
Luiz Awazu PEREIRA DA SILVA
Frédéric SAMAMA
Romain SVARTZMAN

(*) Deputy-General Manager at the Bank for International

Settlements. The view expressed here are my own and my co-
authors and do not necessarily represent those of the BIS and
other institutions.
 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
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 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
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)
3
 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)

4
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

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

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 Ex 2: Climate-related risks vs. uncertainty – Transition risks
Uncertainty v-a-v sector and firm-level exposure Uncertainty related to technological change
to climate related-risks The 2100 primary energy mix (in ExaJoules)
Economic and financial interconnectedness

Source: Campiglio et al (2017)

Sources: Bolton et al. (2020), based on Carbon Brief
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(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 Surge in jobless, short-time workers Global stocks2

Diffusion index Millions Millions 1 Oct 2019 = 100

Sources: Consensus Economics; Datastream; IHS Markit; national data; BIS calculations.
 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:
A. Institutional arrangements: more coordination locally and globally?
B. Production and logistics; new phase of globalization?
C. Macroeconomic policies: how to cope with more debt, more demand for public goods?
D. Social challenges and distributional effects
14 E. 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
15
deal with global pandemics; procedures to alert, data and information sharing, etc.
 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?
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 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
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THANK YOU
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