Are central banks and financial supervisors getting it badly wrong in how they approach environmental risks? Katie Kedward, Josh Ryan-Collins and Hugues Chenet make a convincing case they are, in a paper for the UCL Institute for Innovation and Public Purpose.
They look at the broad sweep of environmental threats, from deforestation to pollination to — inevitably — animal-to-human disease transmission. Conventional sustainable finance often overlooks these and concentrates more specifically on climate change.
However, this diverse set of other issues should not be seen as separate from and less significant than climate change: they interact with each other and with climate change in various feedback loops, for example with deforestation worsening the ability of the planet to soak up carbon. These linkages can play out in ways that are incredibly difficult to predict or model, over different timescales and from an ultra-local to a global scale.
That inability to predict is an important strand of the trio’s argument. Rather than trying to model exactly how the environment will look, it would be more useful simply to do what we can to avoid a “tipping point”: the threshold past which disasters are inevitable and irreversible.
As with climate change, we know that these risks spill over into financial and economic systems, through for example disruptions to supply chains when suppliers rely on the natural world, sudden demand shocks as people turn away from unsustainable practices, and various second and third order effects.
Much of the discourse in sustainable finance focuses on environment risks to the financial system, but the authors point out that it is not just a one way street. Short-termism in finance, for example, can exacerbate environmental problems: such as through encouraging agricultural land to be used for crops that are associated with deforestation, like soy and palm oil.
Supervisory proposals have so far often been based around the idea of “fixing” the market through more transparency and better data. If only banks and investors actually priced in the risk of climate change, the theory goes, capital would shift into more sustainable uses.
But the authors point out that it is very difficult to model accurately the vast array of interconnecting environmental risks, given how little we know, particularly when we move away from focusing only on companies’ carbon emissions.
They propose a different type of supervisory response, which they term a “precautionary” one. Rather than pouring time into developing wonkish models in order to solve an insoluble information gap, they recommend acting on the basis of rules of thumb and qualitative judgements. They point out that in the recent market meltdown earlier this year — in the face of an unprecedented and unpredictable threat — supervisors and central banks acted decisively using their own experience and discretion, and not because of “sophisticated quantitative risk modelling”.
It is a persuasive argument, and regulators may end up concurring: let’s remember how far supervisory policy has shifted in the last decade or so, both in embracing macroprudential policy and specifically on recognising climate threats.
Meanwhile, in focusing on the interlinkages between environmental threats, the paper highlighted to Keeping Tabs the importance of having scientists in the room when deciding the appropriate economic and financial policy response. This has been made clear too in governments’ attempts to counter the coronavirus crisis.
Making young people happy
Elsewhere, but staying on the central bank theme, Philip Bunn and Alice Pugh make an interesting case at Bank Underground, the blog written by staff at the Bank of England, that the Old Lady’s monetary policy since 2007 increased citizens’ well-being, compared with what it would otherwise have been. The vast majority of the gain, they estimate, came from lower unemployment and financial distress.
Central banks are under plenty of scrutiny over the distributional effects of loose monetary policy — i.e. the extent to which inflating the value of financial assets has increased inequality — while savers are not so happy either. In this context, the Bank of England may have another argument to add to its defence, although some may debate how accurately you can really measure wellbeing, of course.
Bunn and Pugh calculate that younger households benefitted the most, as they tended to have more precarious jobs and larger debts.
Finally, on to fiscal policy. Felipe Villarroel, portfolio manager at TwentyFour Asset Management, reckons that we should probably not be worrying about ballooning government debt in the G7 countries.
He makes the point that lower interest rates make the higher debt load more affordable, while subdued inflation expectations, rising current account surpluses or narrowing deficits, and central bank purchase programmes, will allow countries to roll over the debt.