Courtesy of Joseph Smith
Can the current health crisis teach us about the looming environmental one? I think so, particularly as a study of horizons in both time and space.
While there is consensus among experts that climate change is real and its potential impact catastrophic or worse, there is also consensus that the worst-case scenarios will occur at an indeterminate time in the future. In a seminal address on the implications of climate change for financial stability, Mark Carney, then-Governor of the Bank of England, defined this difficulty as follows:
Climate change is the Tragedy of the Horizon… We don’t need an army of actuaries to tell us that the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors – imposing a cost on future generations that the current generation has no direct incentive to fix. … once climate change becomes a defining issue for financial stability, it may already be too late.
While Mr. Carney was right to focus on the cost to future generations, the difficulty for supervisory agencies is in the here and now: whether and how to require financial institutions to pay the cost today (through direct and indirect regulatory exactions) for damage that will occur in the future. Such exactions – more stringent capital and/or regulatory compliance requirements, limitations on business activity – could have an adverse impact on current economic activity. To the extent that such exactions are among the “transition costs” that much of the current literature on climate risk discusses, they may themselves be a source of systemic financial risk.
In addition to the issue of time horizon, climate change also involves what I would call “space horizon.” Space horizon focuses on how you see and feel the consequences of climate change. Climate events– floods, fires, storms droughts – are not a new phenomenon: we have had them literally forever. In general, the impact of them is severe but local. If you are in a flood (as I have been), it’s a disaster; if not, it’s an unfortunate occurrence. Hurricanes Katrina and Harvey, Super Storm Sandy, and the wildfires in California and Australia, were horrific, but none of them has threatened the global financial system. In the public mind, climate disasters are something that happens to other people. This will be true until, as climate activists point out, it isn’t.
Covid-19, on the other hand, is present in both time and space. Its effect is global; it reaches, potentially, everyone on Earth. And, while its incidence is still uncertain, its effect on those infected by it is not. Its universality distinguishes the Covid-19 epidemic from another health disaster: the opioid epidemic that is devastating “left behind America.” In the latter case, the “deaths of despair” that are its outcome are happening to “somebody else.”
Unlike climate events to date, Covid-19 is having a devastating impact on economies around the world and, through such impact, threatens financial stability. Capital markets have crashed, or frozen, or both. In the US, the Federal Reserve has dramatically reduced its policy rate and has flooded capital markets with liquidity to keep them from freezing up. Congress and the Administration have negotiated a stimulus bill, among other things, to counteract the effect of both the virus itself and its impact on the economy. All of this is eerily reminiscent of the actions taken in 2008 to address the bond market meltdown and the financial crisis that followed. As in 2008, public trust and confidence in government hinges on the continued strength and effectiveness of its response to the crisis.
So, what lessons, if any, does the Covid-19 crisis impart to the discussion of climate change and financial stability? Let me suggest a few:
- An ounce of prevention, as it turns out, is worth a pound of cure. Governmental authorities have come to understand that earlier, stronger interventions are more effective—in financial, political, and social terms—than later and weaker ones.
- Coordination of policy interventions is crucial. Financial supervisory agencies are much more likely to be effective in addressing climate change as part of an overall governmental policy stance, as in the EU, rather than alone, as is the current case in the US.
- Global policy coordination is essential. Rising tides and hurricanes don’t respect borders. Travel restrictions don’t apply.
- Risk calculation needs to reflect the interconnections of the global economy and to grow with experience. While the possibility of something like Covid-19 has been known for a long time, its role in starting a price war in the global oil market probably was not. In the case of climate, it is possible that a second or third order effect will cause systemic disruption.
- Climate change is more serious than Covid-19. It is not unduly optimistic to think that the world will survive the coronavirus pandemic. The same cannot be said with confidence about the climate tipping point.
The foregoing ideas are for starters only. The discussion of climate change, when it returns to center stage, will be enriched by the crisis that we will have just seen off.
As an experienced bank supervisor, I have some concerns about whether and how financial supervisors should intervene in policy implementation regarding climate change. Predictions from the first Earth Day about the coming apocalypse haven’t weathered well (pun intended) and the uncertainties around the timing and severity of future climate events make stress testing a challenge. Infelicitously crafted regulatory and supervisory exactions could do short-term harm without long-term benefit. That said, the evidence about climate change and its consequences continues to grow and time is running out. If the Covid-19 pandemic teaches nothing else, it’s that our future depends on carefully considered but forceful and coordinated action.