Green swans: a tipping point for global finance

The concept emerged with­in the Bank for Inter­na­tion­al Set­tle­ments, an insti­tu­tion whose man­date includes coordin­a­tion between cent­ral banks and there­fore fin­an­cial sta­bil­ity. We took inspir­a­tion from “black swan,” a notion developed by Nas­sim Nich­olas Taleb, which evokes the extreme impact of cer­tain types of rare and unpre­dict­able events. Taleb’s book was pub­lished in 2007, just before the fin­an­cial crisis that came as an illus­tra­tion of his idea.

For Taleb, although events of this type do some­times occur, their prob­ab­il­ity remains low. They are con­fined to the tail of the dis­tri­bu­tion of a fairly clas­sic­al Gaus­si­an prob­ab­il­ist­ic uni­verse. The idea of “green swans”, how­ever, is an epi­stem­o­lo­gic­al break from this dis­tri­bu­tion because cli­mate change is turn­ing the tables. We now know with cer­tainty that extreme impact events will occur in the com­ing dec­ades. We also know, and this is quite wor­ry­ing, that if we do noth­ing to reverse the course of this evol­u­tion, points of no return will be reached, with inter­twined con­sequences. For example, rising sea levels will dir­ectly affect many coastal urb­an areas, with cas­cad­ing con­sequences: some will become unin­hab­it­able, oth­ers will require huge invest­ments, prop­erty prices will suf­fer shocks, and insur­ance costs will increase. Sim­il­arly, the inter­trop­ic­al zone could become unin­hab­it­able if days of over 45°C become per­man­ent rather than excep­tion­al. Here again, the demo­graph­ic, eco­nom­ic and polit­ic­al con­sequences are inter­twined and can become very dif­fi­cult to man­age: one crisis leads to anoth­er, and so on. Just as in 2008 the very sharp cor­rec­tion in the US prop­erty mar­ket degen­er­ated into a bank­ing crisis, then a glob­al fin­an­cial crisis, then a euro crisis, then a polit­ic­al crisis with the rise of populism.

This brings us to the idea of the “green swan”: events with extreme impact will occur, whose con­sequences will inter­twine as they become more frequent.

At the BIS, we have sculp­ted this debate through the lens of fin­an­cial sta­bil­ity, because that is the core of our man­date. To put it simply: these events pro­duce losses on the bal­ance sheets of fin­an­cial insti­tu­tions (banks, insur­ance com­pan­ies, pen­sion funds). These poten­tially huge losses are some­times unin­sured. Fin­an­cial insti­tu­tions are not yet able to absorb them (not­ably because they do not have enough equity). There is there­fore a risk of crisis.

Oth­er play­ers in our field have taken this think­ing a step fur­ther, by look­ing at price sta­bil­ity: for example, drought affects agri­cul­tur­al pro­ductiv­ity and thus causes inflation.

There is a third level of think­ing: “trans­ition risks.” When we start to con­sider new con­straints, in this case CO2 emis­sions, we must acknow­ledge that imple­ment­ing new reg­u­la­tions might lead to a whole series of shocks: some indus­tries’ value will increase, oth­er indus­tries’ value will decrease, some may even dis­ap­pear or see their eco­nom­ic mod­el dra­mat­ic­ally dis­rup­ted. These shocks will res­ult in changes in the banks’ bal­ance sheets. A simple change in reg­u­la­tions can cause a sharp decline in the value of cer­tain assets. It is pos­sible to anti­cip­ate this effect – the oil com­pan­ies, for instance, are work­ing on it. But still, a mass sale of their shares would influ­ence fin­an­cial stability.

We are not talk­ing here about “simple” fin­an­cial crises, which are tra­di­tion­ally the domain of cent­ral banks; we are talk­ing about some­thing else.

Fourth level of reflec­tion: asset clas­si­fic­a­tion, with the risk of mis­clas­si­fic­a­tion. A trans­ition policy requires a reori­ent­a­tion of invest­ment flows towards cer­tain activ­it­ies. Clas­si­fic­a­tion is thus a power­ful tool, since they guide massive invest­ments. But some clas­si­fic­a­tions are not pre­cise enough as they mix vari­ous cri­ter­ia. This makes it dif­fi­cult for investors to dis­cern and make the right moves. One example is ESG (envir­on­ment­al, social and gov­ernance) cri­ter­ia. Yet clas­si­fic­a­tions guide massive quant­it­ies of invest­ments. Even­tu­ally, very pre­cise cri­ter­ia will be needed to avoid gre­en­wash­ing. In par­tic­u­lar it should be man­dat­ory for each and every com­pany to pre­cisely assess and dis­close its car­bon foot­print, along with its strategy to get closer to car­bon neut­ral­ity. It is the role of super­visors and reg­u­lat­ors to ensure that this inform­a­tion is increas­ingly avail­able and gran­u­lar. At the BIS, we have star­ted to build port­fo­lio models.

The ques­tion of clas­si­fic­a­tions and new cri­ter­ia has giv­en rise to an unre­solved debate with­in cent­ral bank­ing circles: how should cent­ral banks take these new cri­ter­ia into account when they buy back assets, or when they accept col­lat­er­al? Cent­ral banks can­not do everything, but they do play a cru­cial role in fin­an­cial sta­bil­ity and their instru­ments are so power­ful that they will play a role in the energy trans­ition. Non­ethe­less the main instru­ment of the trans­ition, set­ting a price for car­bon, is out of their reach: such respons­ib­il­ity belongs to gov­ern­ments. Some cent­ral bankers con­sider that it is their duty to act since gov­ern­ments are not doing enough, while oth­ers point to the risk of mor­al haz­ard: if cent­ral banks decide to act, gov­ern­ments will do even less.

How­ever power­ful the insti­tu­tions in charge of fin­an­cial sta­bil­ity may be, and how­ever advanced they may be in under­stand­ing new risks, they can­not act alone. They can­not sub­sti­tute for policy; in fact, the oppos­ite is true. We are not talk­ing here about “simple” fin­an­cial crises, which are tra­di­tion­ally the domain of cent­ral banks; we are talk­ing about some­thing else.

No single act­or will be able to provide the answer. The first chal­lenge for action is coordin­a­tion, which brings us dir­ectly back to the work of Nobel Prize-win­ning eco­nom­ist Elinor Ostrom on the gov­ernance of the com­mons. We need to get our act togeth­er, to set an organ­iz­a­tion so that sci­ence can play a role. Here I shall add an essen­tial point: we must act as if there will be no altern­at­ive tech­no­logy and ensure that the cost of insur­ance is available.

Indeed. And this con­cerns both private and pub­lic invest­ments. We need to mobil­ize pub­lic cap­it­al and not just dir­ect private cap­it­al flows. Alli­ances will also be needed. These have begun to devel­op – think of the Glas­gow Fin­an­cial Alli­ance for Net Zero, which was launched in 2021 and brings togeth­er fin­an­cial insti­tu­tions, or the Net­work for Green­ing the Fin­an­cial Sys­tem (NGFS), a net­work of more than 100 cent­ral banks and fin­an­cial super­visors that aims to accel­er­ate the scal­ing up of green fin­ance and to devel­op recom­mend­a­tions on the role of cent­ral banks in cli­mate change.

We must act as if there will be no altern­at­ive tech­no­logy and ensure that the cost of insur­ance is available.

The role of these alli­ances is to push for a change in prac­tices and the imple­ment­a­tion of new instru­ments, but also to dis­cuss them. This for­um format is essen­tial to bring out prob­lem­at­ic aspects, for it is a cru­cial issue to ima­gine the unima­gin­able. The NGFS has made a point of devel­op­ing “dis­cord­ant” scen­ari­os, includ­ing the “dis­orderly trans­ition”: the situ­ation keeps deteri­or­at­ing and adjust­ments are made too late, with every investor rush­ing to sell their “brown” assets. In this scen­ario, seri­al bank­ruptcies lead to a fin­an­cial crisis. The reflec­tion is there­fore on how to start an orderly trans­ition, with a form of eco­lo­gic­al plan­ning and coordin­a­tion of actors.

The cur­rent rise in energy prices drives us in the right dir­ec­tion, but it also reminds us of the import­ance of redis­tributive policies, since some social groups are par­tic­u­larly exposed to energy price increases. Nev­er­the­less, the cur­rent shock is an oppor­tun­ity that should be seized: how can we use this change in rel­at­ive price as an incent­ive to accel­er­ate the transition?

If we want to ser­i­ously address these issues, all play­ers involved need to work togeth­er and con­sider the dif­fer­ent dimen­sions of the trans­ition. Such coordin­a­tion is far from easy, since it implies a com­bin­a­tion of long and short cycles. The short cycles of polit­ics, par­tic­u­larly, might arise the “tragedy of the hori­zon.” And we should not for­get the “tragedy of com­mons,” with the risk of free riders leav­ing the efforts to others.

Finally, at the glob­al level, inter­na­tion­al coordin­a­tion inev­it­ably requires sup­port from the most advanced coun­tries, either through tech­no­logy trans­fer or via an invest­ment fund. The last COP res­ul­ted in the prom­ise of a $100 bil­lion fund, but it is too little.

Inter­view by Richard Robert