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