Mark Carney: Resolving the climate paradox
Text of the Arthur Burns Memorial Lecture by Mr Mark Carney, Governor of the Bank of
England and Chairman of the Financial Stability Board, Berlin, 22 September 2016.
* * *
I am grateful to Alice Carr, Carsten Jung, Ben Nelson and Iain de Weymarn for their assistance in preparing these
remarks.
I. Introduction
It is an honour to give the Arthur Burns Memorial Lecture.
In Arthur Burns' day, financial diplomacy was limited to weighty issues of monetary policy
coordination, particularly the search for a new international monetary system following the
collapse of Bretton Woods.
Your invitation to discuss climate change is a sign of the broadening of the responsibilities of
central banks to include financial as well as monetary stability. It also demonstrates the
changing nature of international financial diplomacy. The quest for a renewal of the Bretton
Woods treaty, with associated protocols and enforcement mechanisms, has been replaced
with the more flexible governance of the G20 and the FSB. These groups gather principals
who work together to forge consensus and implement global solutions to common problems.
When I spoke at Lloyd's of London a year ago about the financial stability risks arising from
climate change, I, in effect, highlighted two paradoxes.1
First, the future will be past. That is, climate change is a tragedy of the horizon which
imposes a cost on future generations that the current one has no direct incentive to fix. The
catastrophic impacts of climate change will be felt beyond the traditional horizons of most
actors including businesses and central banks. Once climate change becomes a clear and
present danger to financial stability it may already be too late to stabilise the atmosphere at
two degrees.
The second paradox is that success is failure. That is, too rapid a movement towards a
lowcarbon economy could materially damage financial stability. A wholesale reassessment of
prospects, as climate-related risks are re-evaluated, could destabilise markets, spark a
procyclical crystallisation of losses and lead to a persistent tightening of financial conditions: a
climate Minsky moment.
Resolving these conundrums requires first distinguishing the three channels through which
climate change affects financial stability.
The first concerns the physical risks that arise from the increased frequency and severity of
climate- and weather-related events that damage property and disrupt trade.
At present, general insurers are on the front line.2 Thus far, a combination of sophisticated
forecasting, a forward-looking European insurance capital regime and business models built
around short-term coverage has left insurers relatively well-placed to manage physical risks.3
Which is why Warren Buffett can observe that climate change is not a threat to Berkshire
Hathaway's insurance business.4
Insurers have to update their models constantly and adjust coverage prudently. And in time,
growing swathes of our economies could become uninsurable absent public backstops -
hardly the prescription for a growing business.5
Moreover, if coverage is not maintained, the broader financial system would become
increasingly exposed to large and variable physical risks.
With their motives as global citizens sharpened by commercial concerns, insurers have some
of the greatest incentives to understand and tackle climate change in the short term. For
example, Lloyd's of London underwriters are required to consider climate change explicitly in
their business plans and underwriting models. Their genius has been to recognise that past
is not prologue and that the catastrophic norms of the future are in the tail risks of today.
With such insights, it is perhaps not surprising that the insurance sector has been particularly
active in organising itself to address these existential issues.6
The second channel concerns liability risks. These stem from parties who have suffered
loss from the effects of climate change seeking compensation from those they hold
responsible. Such claims could arise well into the future, as the science and evidence of
climate change hardens, though some are already taking action against companies on the
grounds of failure to disclose the risks posed to their business models by climate change.7
The final and most important channel involves transition risks, which could result from the
adjustment towards a lower-carbon economy. Changes in policy, technology and physical
risks could prompt a reassessment of the value of a large range of assets as costs and
opportunities become apparent.
The speed at which such re-pricing occurs is uncertain but could be decisive for financial
stability. There have already been a few high profile examples of jump-to-distress pricing
because of shifts in environmental policy or performance.
Tonight, I would like to discuss how building new markets - in climate transition and green
finance - can help resolve the tragedy of the horizon. Over the past year, the focus of G20
Leaders and the aegis of the FSB have spurred important progress. The upcoming German
presidency of the G20 now has a historic chance to mainstream climate finance and turn risk
into opportunity.
To add impetus, there is also a growing macroeconomic case for action. Let me begin with
that imperative.
4
Buffet noted "insurance policies are customarily written for one year and repriced annually to reflect changing
exposures. Increased possibilities of loss translate promptly into increased premiums". See:
http://www.berkshirehathaway.com/letters/letters.html.
5
The report 'Risky Business - the economic risks of climate change in the United States' (2014) suggests that
in the USA $238-507 billion worth of coastal property could be below sea level by 2100.
6
The Insurance Development Forum was formed in 2015 as a public-private partnership between the United
Nations Development Programme, the World Bank and the insurance sector to use the industry's expertise to
insure people in developing countries who are unprotected but vulnerable to climate change risk. This
protection gap currently represents 90% of the economic costs of natural disasters that are uninsured.
7
In late 2015, the New York Attorney General launched an investigation into allegedly insufficient disclosure of
climate change risk by a large energy company; Attorneys General in numerous US states have since joined
this investigation or launched their own.
II. The macroeconomic imperative
Throughout this decade, global growth has serially disappointed as the combination of huge
debt overhangs, profound demographic changes and enormous uncertainties have weighed
on activity (Chart 1).8 Nominal growth in the euro area, the UK and globally, is running at half
of its pre-crisis rate.
Chart 1
Consistent downward revisions to GDP growth forecasts
Actual GDP growth 2011 2012 2013 2014 2015 2016 2016
Per cent
8.0
Dotted lines = Emerging economies
Solid lines = Advanced economies
6.0
4.0
2.0
0.0
2010 2011 2012 2013 2014 2015 2016
Source: IMF World Economic Outlook. Each line shows how forecasts for a particular calendar year have
evolved over time. The diamond shows the eventual outturn.
Growth has been weak despite significant progress repairing the financial system, recent
moves to somewhat expansionary fiscal policies in a number of countries, and of course,
years of unprecedented monetary policies.
Three eras of uncertainty: geopolitical, economic and policy
Geopolitical risk index UK Economic uncertainty UK Policy uncertainty
3
Scottish
Northern Rock & Global
Independence
financial Crisis
Gulf war
9/11 Iraq Invasion
Referendum
2.5
Lehman Brothers
Failure
2
mean
1.5
from
1
0.5
deviations
0
Standard
-0.5
-1
-1.5
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: Bank calculations and Caldara and Iacoviello (2016), Baker et al (2015), and Haddow et al (2013).
Economic policy and geopolitical uncertainty indices are de-meaned and shown relative to their respective
standard deviations. Chart shows two-year centred moving average for each measure. See Caldara, D and
Iacoviello, M (2016), "Measuring geopolitical risk", Federal Reserve Board, mimeo; Baker, S, Bloom, N and
Davis, S (2015), "Measuring economic policy uncertainty", NBER Working Paper No. 21633, October; Haddow,
A, Hare, C, Hooley, J and Shakir, T (2013) "Macroeconomic uncertainty: what is it, how can we measure it and
why does it matter?", Bank of England Quarterly Bulletin, Q2.
Further restraining growth is a deep risk aversion amongst businesses and investors
stemming from a combination of elevated geopolitical, economic and policy uncertainties
(Chart 2).
This has particularly affected business investment. Across advanced economies, investment
has fallen by more than 21⁄2 percentage points of GDP (Chart 3), creating substantial
investment shortfalls, relative to pre-crisis trends, of around 20% in Germany and 25% in the
UK and US (Chart 4).
In financial markets, despite a recovery in equities in recent years, equity risk premia are
unusually high and government bond yields are consistent with very low growth for a very
long time (Chart 5).9
In short, both business and investors appear to be hedging future disaster risk.
9
In the UK and Germany, real interest rates are negative as far as the eye can see. Even in the US, real
30-year rates are well below 1%. Low bond yields suggest that market is discounting low future growth,
accounting for some of the wedge between those yields and equity dividend yields. Indeed, year in, year out,
earnings forecasts have proven wildly optimistic. However, risk premia are also likely playing a role. Put
simply, investors are not only less optimistic about future growth, but are also less certain about that subdued
outlook. They are demanding a discount on risky assets to compensate, and seeking risk-free assets instead.
Advanced economy investment has Whole economy real investment
fallen relative to GDP and remains substantially weaker than
lower than past episodes pre-crisis forecasts
Residual Equipment
1980 1989
pp fall in investment
Non-residential Residential Per cent
share of GDP
2001 2007 Total
10
1.0
0.5
0
0.0
-10
-0.5
-1.0
-20
-1.5
-2.0
-30
-2.5
-40
-3.0
-3.5
-50
-4.0
-60
-4.5
T T+1 T+2 T+3 T+4 T+5 T+6 T+7 T+8 US UK
Italy
Spain
Years France
Canada
Sweden
Denmark Germany
Switzerland
Source: IMF World Economic Outlook and Bank Source: IMF World Economic Outlook and Bank
calculations. calculations.
Chart 5
UK equity risk premium up since 2000, and together with lower growth
expectations, explains bulk of the spread between earnings yield
on equities and bond yields currently
Percentage points
12
Unexplained component
10
ERP contribution
8
Growth contribution
6
Equity-bond yield spread
4
2
0
2000 2005 2010 2015
-2
Source: IMF, Bloomberg, Thomson Reuters Datastream and Bank calculations. The equity-bond yield spread
is the difference between the reciprocal of the FTSE All-Share price-earnings ratio and the UK 10-year
government bond yield. The growth contribution is calibrated from the IMF 5-year-ahead world growth and
inflation forecasts. The ERP contribution is calibrated using the VAR model described in Chin and Polk (2015),
'A forecast evaluation of expected equity return measures', Bank of England Working Paper, No. 520.
The Bank of England has long stressed that central bank policies are not the cause of low
rates but responses to them.10 We are actors in a play written by others.11
That is because the level at which interest rates must ultimately settle to ensure demand
consistent with supply and so inflation at target - the "equilibrium" interest rate, or "r*" - is
determined, not by central banks, but by the real, fundamental factors driving desired savings
and investment in the global economy.
These include technology growth, demographics, the ease of financial intermediation, and
inequality. Colleagues at the Bank have estimated that such factors have conspired to lower
real interest rates by around 450 basis points since the early 1980s.12
Long-run prosperity was never in the gift of monetary policy makers. As the 10th anniversary
of the start of the crisis approaches, a consensus is growing that escaping this low-growth
low-inflation trap will require a rebalancing between monetary, fiscal and structural policies.
The last are the most important. In addition to their merits in raising potential growth directly,
structural reforms could improve the savings and investment balance, thereby increasing
equilibrium interest rates (r*) and giving monetary policy more traction.
Bank staff estimate that shortfalls in public investment represent only a modest portion of the
450 basis points fall in global interest rates since the early 1980s.
Clear policy frameworks that encourage sustained private investment are thus essential,
including those that mobilise private investment to finance the transition to the low-carbon
economy. As I will discuss, the magnitudes required are significant, the horizons long, and
the distribution Pareto improving.
Theory suggests capital should flow from advanced to emerging economies - where the
returns are highest. For long spells, however, the opposite has happened, confounding the
textbooks and further driving down advanced economy bond yields. And on the occasions
when capital has flowed to emerging markets, it has been too volatile, amplified cycles,
distorted asset prices and fed credit imbalances in recipient countries.
In this context, green finance is a major opportunity. By ensuring that capital flows finance
long-term projects in countries where growth is most carbon intensive, financial stability can
be promoted. By absorbing excess global saving, equilibrium interest rates can be raised and
macroeconomic stability enhanced. And by allocating capital to green technologies, the
prospects for an environmentally sustainable recovery in global growth will increase.
Seizing this opportunity requires a comprehensive climate policy framework.
III. Paris brings forward the horizon
With the Paris Agreement, governments have stepped up.
In a display of international coordination of which Arthur Burns would have been proud, world
leaders committed to curb carbon emissions and limit the rise in global average temperatures
relative to those in the pre-industrial world to 2°C, and to pursue efforts to limit the
temperature increase to 1.5°C.13
Underpinning the Paris Agreement is recognition that the stock of greenhouse gases in the
atmosphere should not exceed the remaining carbon budget, which according to the
Intergovernmental Panel on Climate Change (IPCC) amounts to 1000 gigatonnes of CO2
from 2011 onwards.14
Countries have set their ambitions by submitting their Nationally Determined Contributions
(NDCs).15 At present, these commitments are of varying degrees of specificity, and most still
need to be fleshed out to be consistent with the aggregate carbon budget. The Paris
Agreement requires that NDCs be updated regularly and that each should be a progression
on the last.
Crucially, the Paris Agreement provided an objective assessment that, even if all of the
policies implied by the Agreement were implemented, global temperatures would rise by at
least 2.7 degrees by 2100.16 In other words, the world has committed to do something, but
not yet enough to meet its stated goals.
Therefore, Paris clarifies actual and stretch objectives. It provides detailed climate policies
and creates the prospect of a future ratcheting up of efforts. In doing so, it greatly increases
transition risks as well as opportunities. By bringing forward the horizon, it puts a premium on
the ability of private markets to adjust.
IV. Building a market in transition to a low-carbon economy
Smooth adjustment is crucial because transition risks are how success could turn into failure.
Specifically, sudden changes in policy, technology and physical risks could prompt a
reassessment of asset values as costs and opportunities become apparent. In other words,
an abrupt resolution of the tragedy of horizons is in itself a financial stability risk.
We have already seen cases where there have been sharp changes in valuations. The
combined market capitalisation of the top four US coal producers has fallen by over 99%
since the end of 2010, and three have recently filed for bankruptcy (Chart 6).17 There has
been similar, albeit less acute, drama for the more diversified German utilities (Chart 7).
Chart 6
US coal sector index and S&P 500 against regulatory
announcements and other demand factors
End-2010 = 100 US$/MMBTU
140
US MATS(b) (c)
US NSPC US CCR(d)
China's
implemented
emissions
200
reduction
(a)
120
plan
US Clean Power
Plan
100
150 announced(e)
S&P 500 (LHS)
80
100
Natural gas
60
price (RHS)
40
50
Dow Jones US Coal
20
Index (LHS)
0 0
2010 2011 2012 2013 2014 2015 2016
Source: Thomson Reuters DataStream, Bank calculations. (a) The Chinese government announced emissions
reductions targets in March 2011, which may have contributed to slowing of coal consumption, including a
marked slowdown in coal imports from the US. (b) Mercury and Air Toxic Standards (MATS) required
installation control technology which a large share of coal plants did not have. (c) New Source Performance
Standards: raised efficiency requirements for new coal units. (d) The Coal Combustion Residuals (CCR) Rule
introduced a set of requirements for the safe disposal of CCRs, commonly known as coal ash, from coal-fired
power plants. (e) Proposed to reduce CO2 emissions by about 30% by 3030.
Chart 7
Share prices of German utilities and DAX 30 index,
against key energy sector regulatory announcement
End-2000 = 100
350
Energy transition plan passed
Ambitious renewables
Renewable energy law passsed
targets
300
Earlier phase out of nuclear plants
passed
decided
E ON RWE
250
ENBW DAX 30
200
150
100
50
0
1999 2001 2003 2005 2007 2009 2011 2013 2015
Source: Thomson Reuters DataStream, Bank calculations.
Markets bring the future forward, with financial impacts often occurring immediately, even if
the real impact is several years into the future. For example, in today's low rate environment,
around 90% of the value of the average German utility bond derives from cash flows beyond
five years (Chart 8).
Chart 8
Net present value of a typical German utility bond with 30 year maturity
% of total NPV
> 5 years < 5 years
100
90
80
70
60
50
40
30
20
10
0
€A yield curve 5% 10%
Discount rate
Source: Bank calculations. A 30-year maturity is representative of bonds recently by German private
utilities in 2015 and 2016.
The point is that the more we invest with foresight; the less we will regret in hindsight.
Financial stability risks will be minimised if the transition begins early and follows a
predictable path, thereby helping the market anticipate the transition to a two-degree world.
And that requires the right information. On this front, there has also been considerable
progress in a short period of time.
V. The task force on climate-related financial disclosures (TCFD) and the need
for better information
An obstacle to a smooth adjustment has been the absence of information to help market
participants make a market in climate-related financial risk. Companies do not know what to
report or how to report it. Investors - even well-informed ones - cannot access the
information they need to assess the risks in their portfolios.
In late 2015, at the request of G20 Leaders18, the FSB established an industry-led Task
Force, under the leadership of Michael Bloomberg. It is developing recommendations for
voluntary, consistent, comparable, reliable and clear disclosures around climate-related
financial risks for companies to provide information to lenders, insurers, investors and other
stakeholders.
Since a private sector solution is needed to get this right, the Task Force consists of a careful
balance of issuers, investors, creditors, rating agencies, accounting firms and climate risk
experts. Members are drawn from advanced and emerging economies, including from the
German energy and auto sectors.19
In April, the Task Force published for consultation its Phase I Report, which took stock of the
existing landscape of disclosure initiatives and set out the scope and objectives of its work.20
Initial findings confirmed that existing schemes vary in their status (from laws to voluntary
guidelines) and in their ambition (breadth and depth of disclosures). Disclosure is currently
incomplete and fragmented, with, for example, only around a third of the top 1000 US
companies producing broadly comparable information on the financial risks posed by climate
change.21
Let me offer an outside observer's perspective on three of the core issues which the Task
Force touched on in its Phase I Report and must address in its Final Report to be submitted
to the G20 early in the German Presidency.
First, static disclosures of current carbon footprints are not sufficient to reveal a company's
climate-related financial risks. Investors and creditors need to know the strategic as well as
the static.
A mix of forward-looking, and sufficiently granular, qualitative and quantitative information is
needed to offer real insight into how climate-related risks and opportunities may impact a
firm's existing and future business lines. This could include information on governance and
management of such risks, and on a firm's mitigation strategy and its financial planning,
including capital expenditures and R&D.
Second, the robustness of a firm's strategy and targets could be further illuminated through
scenario analysis. For investors to price financial risks and opportunities correctly, they need
to weigh firms' strategies against plausible public policy developments, technological
advances, and evolving physical risks.
A full exploration of transition risks may require consideration of financial risks and
opportunities under several scenarios. An important question is what form these scenarios
should take.
One option for a global firm operating across multiple markets could be to apply a transition
scenario that takes into account the NDCs of the countries in which its businesses are
located. This could support analysis of whether a company is under- or over-performing
relative to articulated policy frameworks. Another very relevant scenario is, of course, the
ultimate two-degree goal agreed in Paris.
Firms may develop their own transition scenarios or build on commonly available models.
The latter may prove useful to assess against the commitments made in Paris. Either way,
the assumptions and methodologies will need to be sufficiently transparent to allow for
comparisons and external challenge.
Third, there may be merit in considering a proportionate approach that scales the granularity
of disclosures to the risks faced by firms. As a proxy, Calpers estimates that out of the
10,000 firms in their equity portfolio, 314 are responsible for 75% of the emissions.22
In determining a proportionate approach, I would caution, however, against losing sight of
one of the potential benefits of improved disclosures, namely that of helping to make a
market. This requires that investors have the information they need to seek out prospective
risks and rewards across all sectors, from agriculture to car manufacturing to consumer
goods.
I am pleased to report that the Task Force is getting to grips with these thorny issues and is
on track to report to the FSB later this year and to submit its Final Report to the German G20
Presidency in early 2017.
VI. Mainstreaming green finance
Financing the de-carbonisation of our economies implies a sweeping reallocation of
resources and a technological revolution.
The International Energy Agency estimates that globally as much as €45 trillion of investment
in total could be needed in power supply and end-use efficiency to meet the two-degree
target agreed in Paris.23 China alone is likely to require around €500 billion a year from 2016
to 2020 to finance its national environmental goals.24 A substantial proportion of this is likely
to be raised off shore, absorbing excess global savings, helping to push up global equilibrium
interest rates, and ultimately increasing global growth.
With investment in long-term infrastructure assets needing to quadruple, green investment
represents a major opportunity for both long-term investors and macroeconomic
policymakers seeking to jump-start growth. For this to happen, however, green finance
cannot conceivably remain a niche interest over the medium term.
That's why, at the request of G20 Leaders, authorities are exploring ways to mobilise private
capital for green investments. During 2016, under China's G20 Presidency, a Green Finance
Study Group (GFSG)25, undertook a stocktake of institutional and market barriers to green
finance and identified ways to mobilise private capital for green investment.
One proposal is international collaboration to facilitate cross-border investment in green
bonds.
The development of this new global asset class is an opportunity to advance a low carbon
future while raising global investment and spurring growth.
For investors, green bond markets offer a stable, rated and liquid investment with long
duration. For issuers, green bonds are a way to tap the huge US$100 trillion pool of patient
private capital managed by global institutional fixed-income investors. The shift to the capital
markets from banks will also free up limited bank balance sheet capacity for early-stage
project financing and other important infrastructure lending.
The green bond market is gradually gathering speed. Annual issuance rose from just
US$3 billion in 2012 to US$42 billion in 2015.26 It could double this year with issuers ranging
from US regional authorities raising funds domestically to invest in water projects, to Chinese
and Indian corporates, issuing in a range of currencies, in major financial centres, including
London, to finance renewable energy projects.27
Despite this progress, total issuance still accounts for less than 1% of holdings by global
institutional investors.
To reach escape velocity, market participants and public authorities will need to coordinate to
deliver common green bond frameworks and definitions, and other necessary supporting
infrastructure, to build local and cross-border markets.
Specific measures could include:
• Developing a "term sheet" of internationally recognised standardised terms and
conditions for a green bond.
• Creating voluntary definitional frameworks, certification and validation to give
certainty to issuers and investors that the project being financed is "green".
• Integrating environmental risk and green certification into credit ratings.
• Developing green bond indices to unlock the potential investment power of passively
managed investments.
• Assessing the scope for standardisation and harmonisation of principles for green
bond listings to promote efficient trading and adequate liquidity.
Authorities are now working with the private sector to develop a green bond term sheet with
standardised terms and conditions.28 This should significantly improve the ease and
efficiency of green bond issuance and simplify investor access to green bond markets in
multiple currencies, thereby moving them into the mainstream of finance.
VI. Conclusion: markets that value the future
Financial policymakers will not drive the transition to a low-carbon economy. Governments
will establish the frameworks, and the private sector will make the investments.
Nonetheless, financial policymakers do have a clear interest in ensuring the financial system
is resilient to any transition hastened by those decisions. Our role is to help develop the
frameworks for markets to adjust efficiently.
Given the uncertainties around climate, not everyone will agree on the timing or scale of
adjustment required. The right information allows sceptics and evangelists alike to back their
convictions with their capital.
A market in the transition to a two-degree world can be built. It will reveal how the valuations
of companies that produce and use fossil fuels might change over time.
It will expose the likely future cost of doing business, paying for emissions, changing
processes to avoid those charges, and tighter regulation.
It will help smooth price adjustments as opinions change, rather than concentrating them at a
single climate "Minsky moment".
And it would allow feedback between the market and policymaking, making climate policy a
bit more like monetary policy, with policymakers learning from markets' reactions, and
markets internalising policymakers' objectives, strategies and instruments.
When rates are low, the present value of future returns and risks are greater.
That is why a vocal minority are already calling on businesses to invest for the future,
including by supporting the transition to a low carbon economy, and for investors to
internalise the risks and opportunities of climate change.29
With better information as a foundation, we can build a virtuous circle of better understanding
of tomorrow's risks, better pricing for investors, better decisions by policymakers, and a
smoother transition to a lower-carbon economy.
By managing what gets measured, and building a mainstream green bond market, we can
help resolve the Tragedy of the Horizon.
The G20 - whose members account for around 85% of global emissions - has a unique
responsibility. The German Presidency could be decisive.