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Why Central Banks Should Manage Green Swan Risks to Help Mitigate Climate Change

by Jenny Zhong Americas Asia Europe Feb 17th 20226 mins
Why Central Banks Should Manage Green Swan Risks to Help Mitigate Climate Change

Within their financial and price stability mandate, central banks around the world play an important role in addressing new climate-related risks. These players must reduce green swan risks in the financial system, however central banks alone cannot mitigate climate change and its impact on wider society – the responsibility must be shared by governments and businesses alike. 

In August 2021, five members of the US House of Representatives expressed concerns over Jerome Powell’s – the Chair of the Federal Reserve – lax banking policies that could pose a threat to the stability of our financial system, unless the Federal Reserve would include mitigation of climate risks in its mandate. Along the same lines of concern, the British Parliament’s Environmental Audit Committee (EAC) has encouraged the Bank of England to conduct its corporate bond purchasing programme with borrowers’ carbon emissions in mind. 

These groups are among many, urging policymakers and the like to address potential climate risks. The main climate risks include physical risks and transition risks. Physical risks are direct risks of climate change including flooding damaging housing, and storms leading to agricultural yield reduction. Transition risks are social and business-related risks which appear when shifting towards a low-carbon future. For example, Europe has experienced higher energy prices for consumers and businesses because of insufficient energy sources to power the continent during the winter as its coal fuelled plants shut down. 

Among these risks, there are some that are more difficult to manage than others that are termed ‘Green Swan’ risks: potentially extremely disruptive events that could underlie the next systemic financial crisis. 

What is a Green Swan?

The term ‘green swan’ was coined after the ‘black swan’, which originated from Nassim Nicholas Taleb’s 2007 book, The Black Swan: The Impact of the Highly Improbable, referring to unexpected and rare events that have wide ranging and extreme impacts. These events can only be explained retrospectively. For instance, the black swan theory is often cited to describe the 2008 financial crisis. ‘Green swans’ inherit many features of a black swan, highlighting the highly uncertain and non-linear nature of climate-related risks.

Biophysical Roots   

‘Green swans’ are highly uncertain and non-linear because these risks are rooted in the biophysical world. Some examples include the disintegration of the Greenland ice sheet, which will cause rising sea levels and threaten the existence of coastal assets, or permafrost loss would lead to abrupt increases in carbon dioxide and methane through the thawing of frozen carbon-rich soils.

These biophysical phenomena normally exist within a safe operating zone called planetary boundaries; for example, ice sheets will melt to a degree but replenish as the seasons change. The planetary boundary is a critical threshold; going beyond it results in irreversible changes in the state of the system

In the case of Greenland’s ice sheet disintegration, a marginal increase in the warming of the planet could trigger irreversible rapid melting of the Greenland ice sheet, if the planetary boundary is crossed. This could lead to submergence of coastal areas or even inundation of small coastal islands – not only threatening physical assets as collateral. 

Why Should Central Banks Focus on Green Swans? 

Central banks are primary guardians of financial and price stability, leveraging interest rates to achieve these goals. They also act as supervisors to ensure financial institutions are safe and sound; from enacting regulations to risk assessment through stress-testing banks to gauge investment risk and adequacy of assets. ‘Green swans’ threaten the safety and stability of financial institutions – hence it is in central banks’ mandates to address these risks. 

There are two aspects that make ‘green swans’ more concerning compared to conventional risks that arise during the standard business cycle which central banks must address. First, climate risk probability is crucially not reflected in the past data and possibility of extreme values cannot be ruled out – the magnitude and impacts of climate change are highly uncertain. Second, the nature of climate catastrophe is more severe than systemic financial crises as it is rooted in biophysical realities, giving rise to knock-on effects. Lastly, the complexity of climate risks surpasses that of financial risks, as it encompasses hard-to-understand, complex environmental chain reactions that create fundamentally unpredictable environmental, geopolitical, social and economic dynamics.

You might also like: Climate Finance: Are the Rich Nations Doing Enough?

How Can Central Banks Manage Green Swans? 

It is within the central banks’ mandate to encourage disclosures, conduct climate stress tests, integrate forward-looking climate-related risk and scenario analysis into financial stability monitoring and prudential supervision. 

The Network of Central Banks and Supervisors for Greening the Financial System (NGFS) published the first guide for central banks to engage in climate-related disclosures in line with the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD). Through the process of central banks disclosing their strategies for identifying and assessing impacts of climate-related risks and describing how climate risks are integrated into their existing management frameworks, it pushes central banks to consider potential high level climate-related risks and ‘green swans’ they might face. 

Climate stress tests can determine how financial institutions would withstand climate shocks by running their investment portfolios through various climate stress scenarios. For example, this covers physical risks that cause insurance loss and non-performing loans resulting from natural disasters. Thus, the European Central Bank (ECB) has developed a climate stress test to assess the impact on the European banking sector over a 30-year horizon. Some banks have adopted sophisticated policy measures including the Bank of Lebanon, which has employed the differential reserve requirement to support financing the renewable energy and energy efficiency projects. 

Central banks traditionally use backward-looking risk assessments and existing climate/economic models that cannot accurately predict the form in which climate-related risks will take and their effect on the financial system – to identify these risks, forward-looking risk analysis should be used. These forward-looking scenarios are a key tool to gauging the impact of future climate risks for managing investment portfolios. The prospect of ‘green swan’ risk related events force central banks to intervene: banks may find themselves applying larger cuts to investment vehicles exposed to physical or transition risks. 

What Are Some Points of Contention and Limitations? 

Evidently, central banks need to adjust their own mandates of financial and price stability– to proactively avoid the occurrence of ‘green swan’ risks. 

However, despite growing pressures for central banks to address climate risks and ‘green swans’, some contend that the lines of responsibility separating central banks and politicians cannot be blurred. Given the market neutrality principle – which states that central bank interventions such as bond purchase programs must be made in such a way that it does not distort prices of any financial products – some say that central banks cannot provide preferential credit to green activities or companies – even if it means avoiding ‘green swan’ risks in many areas of the financial system. The President of the Bundesbank has argued that “it’s not up to us to correct market distortions and political actions or emissions”. They contend that central banks are limited in what they can do to control climate-related spending and investments as they must stay politically independent and impartial.

Although this prevailing view may be seen as non-level with our current times, it will take more time to change. In the meantime, governments and parliaments have wider powers and tools to steer economies to net-zero. The Green Swan Conference concludes that for central banks, integration of forward-looking analysis is only a part of the solution, and climate-related risks will remain largely unavoidable as long as system-wide action is not undertaken. Governments, civil society, private sectors and more, will all have a role to play in coordinating their own actions aligned with a broader climate goal.

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