Rising greenhouse gas emissions are often talked about as a one-time, irreversible natural experiment with the climate system.
Less discussed is the parallel experiment we are running with our financial system by pumping cash into capital-intensive high-carbon resources. That trend is raising questions of market resilience in the face of an energy transition away from fossil fuels.
Substantial regulation, and then research, went into systemic risk in the wake of the global financial crisis. Where externalities are not priced, imbalances can concentrate in financial institutions creating the potential for corrective shocks.
Moreover, the global financial crisis was evidence of the “fallacy of composition”—the mistaken inference that just because individual firms were safe, the whole system was secure. Further, the behavior of self-interested firms might be rational but socially sub-optimal, making it a mistake to assume that micro-prudential regulation (supervision focused on the transparency and stability of individual firms) — will be sufficient to protect the system as a whole.
In the aftermath of the financial crisis, regulators were provided with more tools, largely to prevent another housing market crash. It is far from clear, however, whether those tools are sufficient to monitor and mitigate the build-up of ecological imbalances in infrastructure and finance attached to a high-carbon economy. We should not squander the time remaining to determine what regulation is needed to protect against similar risks emanating from the energy sector.
Some market commentary has looked at whether the recent energy price decline — historically a boon for the general economy — might not contain the possibility of defaults and contagion. For example, long/short fund manager William FitzGerald draws analogies between the subprime crisis and the energy sector, suggesting that a default cycle in energy could spread, triggering similar soul-searching in the much larger corporate debt market and causing write-downs and a credit crunch.
However, FitzGerald acknowledges that his theory has its detractors, among them the Federal Reserve Chair, Janet Yellen, who has suggested that the effect would be “transitory.” Other commentators see risk to companies, but not contagion.
While any near-term bubble creation is unlikely, FitzGerald’s focus on an initial market misread of a risk and the volatile correction when conventional thinking is disrupted is the right place to look. Here, the gap between “business as usual” forecasts for the energy system and what science tells us is needed to mitigate the worst effects of climate change is significant. Absent formal regulation such as a price on carbon, market actors are not confronted with the price of this risk. This suggests the possibility of imbalances building in the system.
Carbon Tracker’s research suggests that fossil fuel companies are potentially underpricing the risk of an energy transition. Despite the historic volatility in the oil markets, many oil companies left themselves heavily exposed to the recent price decline, such was their confidence in ever-higher prices.
Some capital expenditures have since been deferred or cut altogether, but there is little indication that the curbs are anything other than tending to balance sheets until higher prices return.
Indeed, Exxon’s long-term Outlook (upon which it says it bases its investment planning), forecasts a business-as-usual trajectory for oil over the next 25 years.
It “pays” for these massive emissions by assuming, contrary to its oil trajectory, that coal consumption will be reduced closer to (but not achieving) the amount necessary to give the world a chance of limiting warming to 2°C.
Though Exxon apparently believes that substantial reductions in coal consumption can and will occur, it nonetheless is so confident the same fate will not befall oil consumption that it deems such a low-carbon scenario outside of the reasonable range of scenarios to plan for.
That confidence flies in the face of what we know about the climate, the excess of known fossil resources above the 2°C goal the IEA’s “New Policy Scenario” (which aggregates existing national emissions reductions targets but falls short of the 2°C goal), and the energy transition needed to meet that goal.
It also largely ignores the disruptive potential of meaningful governmental restrictions on climate change, potential gains in efficiency, lower than expected demand, and, perhaps most importantly, declining renewables costs which will act as a “cap” on the prices that oil, gas and coal can command without risk of substitution.
It is bad enough if companies do not shift their business plans to address these risks, but the real concern for financial regulators is if markets misread the extent of the climate problem by building a high-carbon future upon the backs of fossil fuel company confidence about the future. Should mounting environmental problems convince politicians across the political spectrum to act, the only passable remedy will be drastic and its consequences likely financially disruptive.
In short, the question is whether society will commence an orderly withdrawal from carbon-intensive fuels and infrastructure or continue to swell the pool of high-carbon assets that will have to be replaced.
Any energy transition will take decades. This means it must begin now, not years after we have compounded the problem with decades of new high-carbon assets. Simply kicking the can down the road risks an ecological crisis that will require politicians to take drastic actions. Macro-prudential regulators should be proactive rather than wait for these risks to materialize because if and when they do, politicians will ask who was responsible for monitoring this financial experiment gone wrong.
Even if the impacts are long-term, setting up new financial regulatory standards requires immediate action in order to avoid the risk of stranded assets and dysfunctional capital allocation. A high-level roundtable on Thursday at Climate Week in Paris will bring together financial regulators and policy-makers, investors and asset managers to discuss their role in driving an orderly energy transition.
The objective would be to achieve broad consensus and support to form an informal working group on these issues in order to develop a set of principles to be launched in advance of COP21.
Read the first blog: ‘Unlocking funding for a vital low-carbon future’
Read the second blog: ‘Facing up to the fossil fuel risk premium’
Read the third blog: ‘When does the “carbon bubble” become a systemic risk?’
Robert Schuwerk, Senior Counsel at Carbon Tracker and Anthony Hobley, CEO.
 Dirk Schoenmaker, Rens van Tilburg, Herman Wijfels, “What role for financial supervisors in addressing systemic environmental risks?” (Apr. 2015) (citing Brunnermeier, M., Crockett, A., Goodhart, C., Persaud, A. and Shin, H. (2009). “The Fundamental Principles of Financial Regulation. Geneva Report on the World Economy 11, ICBM, Geneva, and CEPR, London.”).
Watch here the short video interview to Carbon Tracker’s CEO Anthony Hobley on this topic.