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Too Late, Too Sudden: Transition to a Low-Carbon Economy and Systemic Risk Daniel Gros Director, Center for European Policy Studies ESRB General Board Frankfurt, 17 December 2015 Outline 1. The adverse scenario 2. Systemic risk in the adverse scenario 2.1 Macroeconomic impact of energy supply shocks 2.2 Financial system exposure 2.2a To fossil fuel firms and stranded assets 2.2b To other carbon-intensive assets 2.2c Global risk dimensions 3. Macroprudential policy implications 3.1 Short-term policy response 3.2 Medium-term macroprudential policy response 4. Next steps and discussion points ESRB General Board Frankfurt, 17 December 2015 2 2 1. Adverse scenario: disorderly transition Physical and transition risks 40 30 20 Amplified by lack of technical progress 10 2050 2045 2040 2035 2030 2025 0 1985 A later transition may also pose larger physical risks from climate change. 1980 • 2020 – Mostly transition risks Projected path Projected path if emissions are fixed at 2014 level Transition path for 2C target if starts in 2020 Transition path for 2C target if starts in 2025 Transition path for 2C target if starts in 2030 2015 Large emissions cuts implemented over a short horizon 50 2010 – 60 2005 The adverse scenario is a “hard landing:” Physical risks 2000 • An early and gradual shift can facilitate a “soft landing” in a low carbon economy (b) GtCO2 per year 70 1995 • The shift to a low-carbon economy will require significant reductions in greenhouse gas emissions 1990 • Source: Bank of England, Prudential Regulation Authority (2015) ESRB General Board Frankfurt, 17 December 2015 3 3 2. Link to systemic risk Adverse scenario could affect systemic risk via two channels: 1. Macro-economic effect due to reduction in energy supply and/or increase in energy costs as external effects are suddenly priced. 2. Sudden negative revaluation of carbon-intensive assets, (i.e. real and financial assets whose value depends on the extraction and/or usage of fossil fuels and other high carbon resources). These two channels could interact with other financial frictions and stimulate negative feedback loops. They might further interact with a third channel: the impact of physical shocks (e.g. natural catastrophes) associated with climate change, which are likely to increase along with temperature. ESRB General Board Frankfurt, 17 December 2015 4 4 2.2a Macroeconomic impact of energy supply and price shocks • • • • Substituting low-carbon for fossil fuel energy quickly will be expensive at the margin. Adaptation of infrastructure may also imply energy shortages and abnormally high energy costs in a transitional period. Increased energy costs has tended to impair economic growth (see e.g. Kilian, 2014). Carbon restrictions affect both energyintensive industries and industries that depend heavily on other carbon-intensive inputs. ESRB General Board Frankfurt, 17 December 2015 5 Greenhouse gas emissions by sector, EU-28 Industrial processes 7% Waste 3% Solvent and other product use 2% Agriculture 10% Transport including international aviation 21.9% Source: Eurostat Energy excluding transport 57% 2.2b Financial system exposure to stranded assets • • Elkins and McGlade (2015) estimate that approximately 35% of current oil reserves, 50% of gas reserves and nearly 90% of coal reserves are ‘unburnable.’ Oil and gas producers: total debt to assets(a) The market values may not currently reflect this risk – HSBC estimated a 50% decrease in market capitalization for oil and gas companies, including both the risk of stranded assets and reduced demand (HSBC, 2013). • Energy production based on very long term assets, often finance mainly by debt • Potential for financial instability. ESRB General Board Frankfurt, 17 December 2015 6 6 Sources: Domanski et al, 2015. BIS calculations based on data from Bloomberg and Thomson Reuters Worldwide, showing me dian and 25-75th percentile. (a) Integrated oil, gas and exploration/production companies. Lar ge US and EMEs include companies with total assets in 2013 e xceeding $25 billion. 2.2b Financial system exposure to stranded assets • The EU financial system may have significant direct exposure to fossil fuel firms. – • Weyzig (2014) estimated this exposure at more than €1 trillion, with potential losses of €350-400 billion even under a “soft landing” scenario. Assets dependent on cheap fossil fuels will also be affected, including carbon- and energy-intensive sectors such as transportation, manufacturing, agriculture, and real estate • Recent macroeconomic modelling estimated that, under a scenario in which markets revalued assets in accordance with policy limiting warming to 2°C, major stock market indexes could fall up to 15-20% (CISL, 2015). • The initial shock could trigger substantial second-round effects, compounded by contagion effects and financial system frictions. • The systemic risk implications depend on the level of exposure to carbonintensive assets and the degree of debt financing, both of are difficult to quantify given available data ESRB General Board Frankfurt, 17 December 2015 7 2.2c Global risk dimensions • The potential systemic implications are compounded by the global nature of transitional risk, particularly for oil and gas exporting countries – State-owned oil firms in emerging market economies contribute a large part of the government budget and are increasing their debt financing (Domanski, 2015) • Emerging markets are also more exposed to physical risk, a ‘global megatrend for sovereign risk’ (Kraemer, 2014) • The EU is comparatively less vulnerable but exposed to vulnerable third countries ESRB General Board Frankfurt, 17 December 2015 8 Section 3: Macroprudential policy implications • The systemic risk implications depend on the level of exposure of individual agents, and highly levered financial institutions in particular, to carbonintensive assets and the specific form of emission abatement policies, both of which are highly uncertain and will vary widely across member countries. • In response to the potential systemic risk involved, macroprudential policymakers could encourage identification and disclosure of carbonintensive assets, and use this information to run dedicated stress tests of financial institutions. ESRB General Board Frankfurt, 17 December 2015 9 3.1: Short-term policy implications • In the short-term, the ESRB could: – Develop a view of the economic/financial implications of a ‘hard landing’. – Support the call for greater information collection and disclosure. • Ensures a timely assessment of the associated potential threats to financial stability – Develop stress testing tools for future use. • A) incorporate risks associated with a “hard landing” into the ESRB’s macroeconomic scenarios used by the ESAs in their regular stress testing of regulated financial institutions. • B) run dedicated “carbon stress tests” to define the most pertinent systemic risks and that could be adapted to the specificities of “hard landing” stress scenarios (such as the long time horizon) ESRB General Board Frankfurt, 17 December 2015 1 0 3.1: Short-term policy implications • • Topic of climate change and financial stability is currently under consideration by several institutions (see right) Opportunities for collaboration within the ESRB on both of these options. ESRB General Board Frankfurt, 17 December 2015 1 1 Institution Initiative Bank of England, PRA Ongoing research, e.g. “The Impact of Climate Change on the UK Insurance Sector.” Financial Stability Board Climate Disclosure Task Force (upcoming) French Treasury Department Stress testing and disclosure requirements People’s Bank of China Green Finance Task Force UNEP Inquiry: Design of a Sustainable Financial System 3.2: Medium-term macroprudential policy response • If research suggests significant exposure to carbon risk under a hard landing scenario, regulators could consider further policy actions: – building systemic buffers so as to protect against the macroeconomic and macrofinancial implications of a "hard landing"; – regulatory loss absorbency requirements, e.g. in the form of the issuance of "carbon risk bonds," the payoff on which would be contingent on a contractually-defined critical event (e.g. the imposition of a high carbon tax or a rise in the price of carbon); – specific capital surcharges based on the carbon-intensity of individual exposures; and – large exposure limits applied to the overall investment in assets deemed highly vulnerable to an abrupt transition to the no-carbon economy. ESRB General Board Frankfurt, 17 December 2015 1 2 4. Discussion points • Thoughts on the short and medium-term policy options • To agree to publication of the note as ASC paper ESRB General Board Frankfurt, 17 December 2015 1 3 References 2° Investing Initiative (2015). “Decree Implementing Article 173-VI of the French Law for the Energy Transition. Challenges and first Recommendations.” Available from http://2degrees-investing.org/. Acemoglu, D., Aghion, P., Bursztyn, L., and Hemous, D. (2012). “The Environment and Directed Technical Change.” American Economic Review, 102(1): 131–166. Bloomberg New Energy Finance (2014). “Fossil Fuel Divestment: A $5 Trillion Challenge.” Brunnermeier, M. K., and Schnabel, I. (2015). “Bubbles and Central Banks: Historical Perspectives.” Working paper. Caldecott, B. and Rook, D. (2015). “Evaluating Capex Risk: New Metrics to Assess Extractive Industry Project Portfolios.” Working Paper. 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(2008). “The economics of climate change.” American Economic Review: Papers and Proceedings, 98(2): 1–37. Tan, G. (2015, July 2) “Regulators Warn Banks on Loans to Oil, Gas Producers.” Wall Street Journal. Tuuli, S. and Batten, S. (2015). “Back to the Future: Why We’re Optimists in the Secular Stagnation Debate.” Bank of England’s Bank Underground blog (http://goo.gl/tfauo3). Unruh, G. C. (2000). “Understanding Carbon Lock-in.” Energy policy, 28(12): 817-830. UNEP (2015). “The Financial System We Need: Aligning the Financial System with Sustainable Development.” Wei, M., Patadia, S., & Kammen, D. M. (2010). “Putting renewables and energy efficiency to work: How many jobs can the clean energy industry generate in the US?” Energy policy, 38(2), 919-931. Weitzman, M. (2013) “The Geo-engineered Planet.” Chapter 10 of In One Hundred Years (Palacios-Huerta (ed.)), MIT Press. Weyzig, F., Kuepper, B., Gelder, J.W. van and Tilburg, R. van (2014). “The Price of Doing Too Little Too Late; the Impact of the Carbon Bubble on the European Financial System.” Green New Deal Series, Volume 11. ESRB General Board Frankfurt, 17 December 2015 1 4 Appendix 1: climate and emissions scenarios • Past and current state of emissions suggest a highly uncertain environment regarding the speed and timing of the low-carbon transition – • • Carbon budget and CO2 emissions Extrapolating from existing emissions pledges and the targets consistent with limiting global warming to 2°C suggests a late, hard transition. Under a soft landing, the low-carbon transition could have an overall positive effect on the economy, given timely investment in alternative energy and infrastructure. (See e.g. Acemoglu et al (2012), Stern (2008), Wei (2010), Fankhaeser (2010)) This soft landing would require a significant but feasible increase in investment and infrastructure (Kaminker, 2012). • The implementation of emissions regulation has shown considerable variability and volatility in establishing a price for carbon emissions, dampening investment in clean energy sources (Masini and Menichetti, 2011; IEA, 2014). • Absent stable price signals and decisive global political commitment against climate change, a hard landing becomes more likely. Source: IEA (2015). Global energy-related CO2 emissions extrapolating from current national emissions pledges under the UNFCC, compared to remaining carbon budget. Carbon futures price under the EU Emissions Trading System Source: Investing.com. Euros per ton of CO2 equivalent, 2008-2014 . ESRB General Board Frankfurt, 17 December 2015 1 5