Blip, crisis or collapse: why financial regulators need to prepare for more than a climate crisis

It’s now or never. That was the headline from the latest summary report from the IPCC describing the need for more urgent action. The “certainty” and “need for urgency” was already abundantly clear. What’s now emerging in the IPCC’s scientific analysis is the irreversibility of climate change – the devastating effects will continue for “centuries or millennia”, long after emissions stop.

When we think about addressing the risks of global climate change, central banking rules are hardly likely to be top of most people’s minds. Banking regulation is often shaped by the response to the last crisis, and central bankers have been reticent to adapt their processes sufficiently to anticipate situations they have yet to experience.

Take the reflection of Ben Bernanke, chair of the Federal Reserve during the global financial crisis. Speaking in 2010, he claimed that “calls for a radical reworking of the field go too far…  Economic models are useful only in the context for which they are designed. Most of the time, including during recessions, serious financial instability is not an issue. The standard models were designed for these non-crisis periods, and they have proven quite useful in that context”.

In other words, the tools we use to keep us safe are often built for the times which we have experienced in the past and don’t include the risks we see ahead of us.

Is financial regulation fit for purpose?

Many commentators have asked: could climate change create a financial crisis like the last one? Thinktanks and financial experts certainly think so. Both Graham Steele at the US Treasury and Brussels-based NGO Finance Watch have warned of a climate Lehman moment. The World Resources Institute has observed that “the climate crisis could absolutely induce a financial crisis”.

So should our financial regulations anticipate and deal with a future financial crisis caused by climate based on previous crises? Well, yes and no.

There is inevitable loss and damage as a consequence of climate change up to 1.5ºC. Central banks will start to open their crisis management toolkit with scenario analyses and stress tests. But the science explains that when we go beyond climate thresholds, overshooting safe limits and triggering feedback loops, then we’re not facing a crisis, we’re facing a collapse.

That’s not just a more exaggerated form of language. It’s a different category with inherently different implications for regulators.

What are we facing – blip, crisis or collapse?

Let’s start by differentiating between the types of downside situations that could face banks, and the turbulence experienced by financial systems can be broadly categorised in three ways.

They often have blips – bumps in the road, economic cycles, shocks, and breakdowns in trust or standards. They translate into losses that are higher than normal. They can be the result of poor judgment, bad luck or bad timing. At a local level it will always bring pain and discomfort – businesses close, jobs are lost. But the financial consequences can be managed at an institutional level by ensuring that financial institutions are run well, that they have good processes and are in control of managing their risks.

A crisis is much more severe and can have destabilising effects. Both the global financial crisis (with its causes inside the financial system) and Covid 19 (with its causes outside) have had wide-ranging economic impacts that were global in nature, triggering recessions around the world felt by individuals and communities.

But as devastating as their impacts can be, crises ultimately have resolutions: the world may suffer loss and damage but from an economic point of view there is “another side” once the crisis has passed. But there is a difference between these crises and what is happening to our climate where irreversibility means there is no resolution.

The financial impact of climate change on our current trajectory will not be a crisis but a collapse. According to the IPCC’s latest report, in scenarios which overshoot 1.5ºC, the impacts of climate change continue, irreversibly, even after all emissions have ceased. The long-term impacts on sea-level rise and loss of critical natural systems continue for centuries or even millennia after all global emissions end.

In financial crises where there is a liquidity shortage, there are mechanisms to “reverse” the damage by creating liquidity. There is no way to reverse the impacts of full-blown climate change within human lifespans.

So if climate change goes beyond the point of no return then there is no longer an identifiable endpoint to reach or crisis to resolve. It cannot be repaired within lifetimes let alone economic cycles. It is the shape of a cliff edge, and it is this level of complete system failure our regulatory frameworks are completely unprepared to deal with. What we see in common in most central bank stress tests and scenario analyses is the assumption that all other things will remain the same – ceteris paribus – when what we are learning from climate science is that nothing will be the same if the world tips beyond thresholds.

Once the glacier melts, there is no putting it back. It is simply an ending – a collapse.

What should financial regulation look like when facing collapse?

If we want to avoid that then the only applicable strategy is a fundamentally more precautionary approach with regulations that steer the financial system more forcefully on environmental risks than we have needed before.

Right now, modelling climate risk is unsurprisingly based largely on extrapolating historical data from our familiar past. This leads to sanguine visions of the future which seem quite financially bearable despite the threat to existence. What’s a few points of GDP here or there?

But latest estimates of economic damage by the end of the century range from 37-51% of GDP – six times higher than previously thought. The parallel collapse in natural systems upon which society and our economies are critically dependent will rapidly render GDP a meaningless measure.

So we don’t just need new models, we need different interventions. If you’re driving towards the edge of a cliff, it’s probably less important to calibrate instruments that will give you an accurate reading on how far you will fall and more important to steer in a different direction.

One would imagine this would be a core objective for regulators. But for now, it is all measuring and no regulating. The ECB’s recent climate and environment risk review of European banks was thorough and comprehensive. They concluded that the majority of banks were not meeting expectations but are yet to implement any consequences.

Along with the ECB, the Bank of England has also shown leadership in investigating climate risk – and just released the results of their 2021 climate stress test. But again, for all their hard work in scenario analysis, they too reveal a level of complacency based upon framing this as “only” a crisis and rely on assumptions of “everything else being the same”. In their opinion they “have made sure that banks now have substantial financial resources to help them weather this and any future storm”.

But going beyond climate thresholds will not be a storm. It can’t be reversed by financial intervention. It will not be a crisis with a resolution. It will be a collapse. And that requires a fundamentally different conceptual approach.

The Climate Safe Lending Network – composed of banks, investors, NGOs and academia – argues that central banks need to steer in a different way, applying capital measures to climate-damaging assets like fossil fuels and deforestation which are sending us in the wrong direction. Measures that would rebalance climate risks would help protect the financial system and help the economy steer away from those risks.

One such measure is the the ‘one-for-one’ proposal. It represents a logical, precautionary approach that is reinforced by the evidence that sustainable alternatives like renewable energy or regenerative agriculture exist and are fully feasible.

There’s a path already built that leads us away from the cliff edge, we just need to follow it.