Central Banks and Climate Risks

These changes have led policymakers and economists to examine what climate change may mean for communities, governments, and the economy. More than 3,000 economists recently signed a statement in support of a carbon tax (see sidebar), and a leading finance journal hosted two conferences in 2017 and 2018 to promote research on the financial risks related to climate change. And as the discussion surrounding climate change heats up, central banks around the world are attempting to understand and prepare for its potential risks.

Challenges to Economic Growth

In a recent article, Riccardo Colacito of the University of North Carolina, Bridget Hoffmann of the Inter-American Development Bank, and Toan Phan of the Richmond Fed found that rising temperatures are associated with reduced economic growth. They analyzed temperature and output growth by season and industry, finding that for every 1 degree Fahrenheit increase in the average summer temperature, the annual growth rate of state-level output decreases by 0.15 to 0.25 percentage points on average. When combined with future temperature projections, their findings indicated that U.S. economic growth could decrease by as much as one-third over the next hundred years if this association continues.

Rising temperatures could influence growth through several different mechanisms. In their article, Colacito, Hoffmann, and Phan pointed to reductions in the growth rate of labor productivity as one such mechanism, citing previous research as well as their own data. Phan suggests that changes in labor productivity alone can't explain their findings, however.

"One potential mechanism could be hotter summer temperatures coming along with more intense disasters like heat waves or wildfires," Phan says. "The effects of disasters can be twofold. If disasters damage physical capital or crops or property, that's one immediate channel. Another channel is through making people more attentive to future risk, which is reflected in asset prices."

He points to a working paper by Piet M. A. Eichholtz of Maastricht University, Eva Steiner of Cornell University, and Erkan Yönder of Concordia University. These authors examined commercial real estate prices after Hurricane Sandy, which hit New York City in 2012, and found that the prices of properties exposed to flood risk appreciated more slowly after Sandy than they did in regions unaffected by flood risk. Remarkably, this trend held not only in New York, but also in Boston, which experienced no physical damage from Sandy. The authors argued that this effect can be explained by a persistent increase after Sandy in the salience of flood risk to investors in coastal areas of Boston.

In addition to their aggregate findings, Colacito, Hoffmann, and Phan analyzed the influence of rising temperatures on output growth at the industry level. They found that higher summer temperatures negatively affected most industries, even those where most work takes place indoors. The most negatively affected sector was, as it happens, the so-called FIRE sector: finance, insurance, and real estate. For central banks, especially those specifically tasked with maintaining financial stability, this result is especially relevant. But how exactly could climate change affect the financial system?

Is Financial Stability at Risk?

Some economists contend that climate change imposes physical and transition risks on the financial system, threatening its stability. In a January 2018 working paper, Sandra Batten, senior economist at the Bank of England, wrote that physical risks arise from a combination of adverse climate-related events and systemic vulnerabilities. These risks, she argued, include both demand- and supply-side shocks to the financial system. For example, on the demand side, rising sea levels might decrease demand for coastal homes, while on the supply side, changes in precipitation patterns could affect crop yields. Climate change may also shift investment patterns by diverting resources to adaptation investments instead of the productive investments that would have been made otherwise.

Extreme weather events, such as droughts, wildfires, and hurricanes, are often named as key sources of physical risk. A recent article in the Journal of Financial Stability by Jeroen Klomp of Wageningen University & Research in the Netherlands supports such a connection. In an analysis of data on commercial banks from over 160 countries, Klomp found that natural disasters are associated with a higher likelihood of bank default, although not of system-wide crisis. The extent of climate change's influence on natural disasters, the study of which is known as event attribution, is an active area of research. A 2016 report by the National Academies of Sciences, Engineering, and Medicine indicates that scientists are most certain when attributing extreme heat and cold, drought, and precipitation to climate change, since these can be directly traced back to temperature changes. Scientists are less confident, however, about the extent of climate change's impact on extratropi­cal cyclones, wildfires, and severe convective storms.

In a recent publication, Glenn Rudebusch, senior policy advisor and executive vice president at the San Francisco Fed, included extreme weather events as one source of future climate-related economic transformation. Rudebusch wrote that an increase in the frequency and severity of extreme weather events, as well as higher temperatures and other consequences of climate change, could adversely affect the economy and financial system by reducing business profitability and asset values, disrupting operations, damaging infrastructure, and weakening labor productivity.

"I think of climate change as a problem multiplier, even where it's not the sole cause. For example, we've always had hurricanes, but a changing climate is going to exacerbate them — and the same is true for economic insecurity and inequality," Rudebusch says.

Along with physical risks, some economists also note the transition risks from a shift toward low-carbon energy sources. In a 2016 report for the German Federal Ministry of Finance, Martin Stadelmann of the South Pole Group, a Swiss consulting firm in the area of climate finance, and Viola Lutz, now at Institutional Shareholder Services, wrote that transition risks present a much greater threat to financial stability than physical risks. Batten wrote that, were emissions-reduction policies to be implemented, short-term output would likely fall as carbon-intensive firms adjust. In fact, some estimates of global losses from transition risks are as high as $20 trillion. And transition risks could also affect monetary policy. In a 2018 speech, Benoît Coeuré, a member of the Executive Board of the European Central Bank (ECB), indicated that a transition to low-carbon policies would affect relative energy prices. He said that this, in turn, could shift inflation expectations, which are directly relevant to monetary policy.

George Economides and Anastasios Xepapadeas of the Athens University of Economics and Business modeled the impacts of climate change on monetary policy in a 2018 working paper. They found that climate change presents shocks to total factor productivity, a measure of how efficiently an economy uses its labor and capital inputs. This means that in the presence of climate change, economic fluctuations tend to be both longer and more frequent than in its absence. But a decrease in output resulting from these shocks also decreases demand for fossil fuels, which boosts productivity by slowing the pace of temperature increases. Finally, they found that while a carbon tax curbs short-run output, it increases long-run output. Their findings indicate both physical and transition risks from climate change and policy.

What We Don't Know Could Hurt Us

Another key feature of climate change is uncertainty about its extent and its economic effects. One area of uncertainty is the extent of temperature increases and the probability of catastrophe. Martin Weitzman, an economist at Harvard University who passed away in August, researched "fat tail" probability distribution functions, in which catastrophic climate change — and thus, catastrophic economic damage — is more likely than is typically assumed in climate models. In a 2011 article, Weitzman argued that, because of the lack of substantive historical data on past catastrophes, it is possible that extreme events are more likely than most models assume. He concluded that cost-benefit analyses of climate change should incorporate this structural uncertainty.

"A fat-tailed model increases tail risk generally. There's more weight in the tails relative to what's expected," Weitzman told Econ Focus. "The huge problem is that nobody knows the probability or consequences."

Uncertainty also affects models of climate change's economic impact. Economists commonly use integrated assessment models (IAMs), which feature both climate science and economic modules, to analyze this issue. The climate science modules project future GHG emissions and resulting global temperatures, while the economic modules estimate the economic consequences of unmitigated climate change and the costs and benefits of emissions-reduction policies. In a 2013 article, Robert Pindyck, a professor at the Massachusetts Institute of Technology, identified significant flaws in these models. First, because they are calibrated only to small temperature increases, they are not informative about the economic effects of a climate catastrophe such as an extreme rise in temperature. Second, they rely on arbitrary constructions of the damage function, an element of the model that estimates economic losses from climate change. Because of these flaws, Pindyck argued, "IAMs are of little or no value for evaluating alternative climate change policies." In a later op-ed, he noted that his critique is an argument not against taking action but for improving the models in order to better guide that action and imposing a carbon tax as a form of insurance in the meantime.

Yet another source of uncertainty is how well societies will adapt to climate change, which could offset some of its downside risks. Stadelmann and Lutz suggested that while large storms could raise insurance premiums, the insurance sector's ability to gradually adjust those premiums could allow it to adapt fairly well to climate change in the short to medium term. This could change in the long term, though, especially if temperatures increase by more than 2 to 3 degrees Celsius. In that case, Stadelmann and Lutz wrote, there is too much uncertainty to reject the possibility of more severe systemic effects. In her paper, Batten gave several examples of adaptation efforts, including investing in physical capital to accommodate new temperature and weather patterns and innovating GHG-removal technology. Adaptation might also entail planting more heat-resistant crops, updating infrastructure in order to better withstand floods, or enacting transition policies such as a carbon tax.

Still, some researchers and officials argue that uncertainty alone does not remove the need for action. "If anything, standard economic theory points us to the fact that when uncertainty rises, we insure against the worst-case scenario," Phan says.

Central Banks' Response

In 2015, Mark Carney, governor of the Bank of England, deemed climate change "the tragedy of the horizon." He warned that "once climate change becomes a defining issue for financial stability, it may already be too late." Four years later, central banks are beginning to incorporate climate-related risks into their economic forecasts. Some are even taking policy steps to mitigate those risks. (See table below.)