Author: Benjamin N. Dennis, Senior Economist, Policy Planning and Strategy Section, FRB
Abstract: This article reviews the rapidly proliferating economic literature on climate change and financial policy. We find: (1) enduring challenges in estimating the statistical properties of a changed climate; (2) emerging evidence of financial markets pricing in climate-related risks; and (3) a range of significant institutional distortions preventing such pricing from being complete. Finally, we argue that geographic regions may be an especially fruitful unit of analysis for understanding the financial impact of climate change.
Introduction: This literature survey addresses the implications of climate change research for policymakers, most specifically those at central banks. At least since Mark Carney began to place emphasis on climate change as Governor of the Bank of England, financial system vulnerability to climate change has been a concern of central banks, and policymakers have grappled with the appropriate role for monetary, financial stability, and banking supervisory and regulatory policy (Carney, (2015)). The basic framework advanced by Carney considers two classes of risk: 1) physical risk—that is, physical damage caused by severe climate events or chronic worsening of conditions as with sea level risk—and 2) transition risk, or the risk to certain sectors of the economy as the structure of economic activity necessarily becomes less carbon intensive. In this framework, central banks must manage risks to the financial system that result from physical climate vulnerabilities as well as from policy imperatives.
This literature review is organized around three fundamental questions with which policymakers must grapple as illustrated in Figure 1. . . .
The first is whether, and to what extent, climate risk is quantifiable. Perhaps most famously described by Knight (1921), [131]), radical (or “Knightian”) uncertainty—defined by Bewley (1988) [31] as, ‘randomness with an unknown distribution’—has been recognized as a challenge for economic decision-making. Unsurprisingly, radical uncertainty does not easily translate into clear tools for risk management. Von Neuman and Morgenstern (1953) [190] demonstrated the advances that could be made when uncertainty can be represented by quantifiable risk. The burgeoning literature on continuous-time finance (see, e.g., Merton, (1992) [147]) ushered in the development of derivative assets and the hedging and risk-management tools that define modern financial markets. These tools are built on the ability to transform financial risks into stationary or otherwise well-behaved functions whose (relative) behavior can be coaxed to yield tractable policy targets that are legible in terms of discoverable parameter values. Often, these targets— for example, credit limits or minimum liquidity thresholds—take on precise values based on careful analysis of historical data. Yet, the limitations of relying on history to contain all the facts needed to protect against future shocks are well known, and they are particularly true for climate change. Section (2) of this paper therefore examines the literature on how to address uncertainty in climate models, and the implications for use of common tools in financial risk management.
The second key question, which we address in Section (3), is whether current market prices for goods and assets are efficient with respect to potential physical and transitional climate shocks. That is, have market participants rationally integrated all currently known information about climate risks into market prices? There are multiple dimensions to this question, and the literature on asset price bubbles is possibly closest in helping to frame the issues involved. However, unlike a bubble, in which the question is whether prices are rising too quickly, the question with climate change is whether certain asset prices, such as coastal real estate, are adjusting downwards quickly enough. Factors stressed by Shiller (2016) [181] among others—such as beliefs (animal spirits) and magical thinking—as well as institutional factors that misalign the burden of risky behavior across market participants are all potentially relevant.
Section (4) turns to the final question, whether climate change imposes specific externalities of its own within the financial system. These externalities can most easily be seen in the macro implications for insurers or widespread climate damage resulting from global shocks. By altering the nature of shocks towards systemic as opposed to idiosyncratic events, much of the load-bearing capacity of risk management tools and institutions may require a macro-prudential approach attuned to the specific threat of climate change.
The examination of the literature that follows suggests that, even though this research is still in its early stages, we have a good sense of how to answer these questions. It remains difficult, if not impossible, to identify a reliable probability distribution of climate events in a warmed world. Economists have developed different approaches to this dilemma, which can result in enormous differences in outcomes, often driven by emergent and unintuitive properties of the models themselves. More promising methods, such as agentbased modeling, are gradually coming within reach as the computing power required for them increases. Other cost/benefit-oriented approaches work with less specific assumptions of climate-related economic costs, generating tractable guidance for general economic policy but not climate-related financial risk. Disputes over discount rates compound the difficulties further.
Studies of financial markets face similar challenges, although with more reliable local results. Most suggest that, while ESG-adaptive equities display some reduced risk premia, the prices of economically specific assets (like real estate) do not fully reflect climate-related financial risks. Agents appear to respond differently to climate-related information “news”; their ex ante beliefs, their ability to exit a market, their ability to mitigate risk, and their access to information can all affect their behavior. In addition, agents’ responses may not be durable or complete. However, literature on this point is less complete, relying heavily on assumptions about sectoral carbon intensity and using physical variables to proxy the intensity of transition-related f inancial risks. Studies of banks are scant. However, a more robust body of literature documents the institutional distortions that keep investors from pricing climate-related risks completely. These distortions include the short time horizon of large institutional investors, which can impair monitoring activities and create moral hazard; principal-agent problems between such investors and their agents, which ultimately reduce returns; network effects, which limit the exposure of any one investor to climate risks without appreciably reducing funding to a climateexposed sector; and the effect of fiscal transfers, which may reduce adaptive behavior in the wake of a climate shock. Such distortions can have secondary effects, such as a substitution to more fully insured assets, with a less direct relationship to climate change. Banks, which seem to have over-performed in the wake of climate events, may be particularly susceptible to these dynamics.
These institutional factors suggest that researchers should place a special focus on the geographic region rather than focusing exclusively on the investor, the consumer, or the financial intermediary. Different regions represent different portfolios of assets—the physical infrastructure, real estate, f irms, and people, which allow it to produce, collaborate, and compete. Each element of this portfolio may have different exposure to climate change. A region’s buildings may be more exposed to sea-level rise or more frequent hurricanes, and its bridges and highways may have a higher baseline level of decay. Its firms may be in industries likely to struggle in a world experiencing climate change—and those firms, and their employees, may be more able to migrate elsewhere as conditions deteriorate. Above all, different regions may bring different financial resources to those challenges from their tax base to their credit rating, to their eligibility for intergovernmental transfers. These resources will allow them to reduce their exposure to climate-related risks or prevent them from doing so. This, in turn, creates a feedback effect on the value of the region’s portfolio. The economic story of climate change— and indeed, the financial on—may be less a story of investors and financial markets than a story of states, cities, and other local governments.
https://www.federalreserve.gov/econres/feds/climate-change-and-financial-policy-a-literature-review.htm