The book cover for ‘The Green Swan’ by the BIS and Banque de France.
There is something peculiar in the book released last January by the Bank for International Settlement and Banque de France, The Green Swan.
The book builds on the concept of ‘black swans’ first introduced by Nassim Nicholas Taleb in 2007, but this time the swan is green. Green swans (or climate black swans), the authors argue, are extreme financially disruptive events resulting from climate-related risks. They believe these risks could be the catalyst for the next systemic financial crisis. Green swans present many features of ‘black swans’ since climate-related risks are characterised by deep uncertainty and nonlinearity (i.e., past data does not reflect the likelihood of a catastrophic climate event, and one cannot rule out the possibility of extreme values: Our greatest threats could be unpredictable).
The Black Swan: The Impact of the Highly Improbable, Nassim Nicholas Taleb (2007)The Black Swan is a book by author and former options trader Nassim Nicholas Taleb that spent 36 weeks on the New York Times best-seller list. The book examines the impact of rare and unpredictable events and the human tendency to find simplistic explanations for these events. Their impact is huge, they’re impossible to predict, and yet we try to rationalise them. The Black Swan shows us how to stop trying to predict everything and take advantage of uncertainty.
Frankly, until recently, much of the financial sector remained unconcerned with climate change. The uniqueness of the idea conveyed by the book is perhaps best characterised by a quote from Victor Hugo cited by the authors: “Rien n’est plus puissant qu’une idée dont l’heure est venue” (which loosely translates as “there is nothing more powerful than an idea whose time has come”). We must brace ourselves for change. The authors argue that the financial sector – central banks, banking supervisors, and financial institutions – must be at the heart of tackling climate change.
The Green Swan is a dense book. It is thought-provoking, insightful, and gripping. I cannot do it justice in just a few lines. I wish here then to single out only three topics for discussion: (a) the assertion that climate change is a source of financial instability, (b) the consequential looming changes in regulation and supervision that the book foretells, and (c) some personal views on what Board Members and Executives could already implement at firm level.
a) Climate Change as a Source of Financial Instability
The Tragedy of the Horizon, Mark Carney (2015)“We don’t need an army of actuaries to tell us that the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors – imposing a cost on future generations that the current generation has no direct incentive to fix.”
When he delivered his, now famous, speech on The Tragedy of the Horizon, in September 2015, Mark Carney, Governor of the Bank of England and Chairman of the Financial Stability Board, appealed to us as parents and as grandparents. Beyond this powerful call to action that resonates with most of us, he noted three channels through which climate change can affect financial stability:
b) Consequential looming Changes in Regulation and Supervision
The Green Swan explores actions required to preserve the mandate and credibility of central banks, regulators, and supervisors in the long term. It contemplates five types of measures, including (a) measures drawing on prudential regulation, (b) disseminating environmental, social, and governance (ESG) standards to break the ‘tragedy of the horizon’, (c) a Green New Deal, (d) calling for international monetary and financial cooperation, and (e) integrating sustainability into corporate and national accounting frameworks.
Banks are currently colourblind. If regulation forces them to differentiate between ‘green’and ‘brown’ assets, they will struggle against challenges for which they’re not yet prepared. [Source here]
All five measures are a great read. Again, however, in the context of this blog, allow me to focus on one only — the measures drawing on prudential regulation.
The authors recommend that climate-related risks be further integrated into both financial stability monitoring and micro‑supervision, starting with the integration of climate scenarios into existing regulatory stress tests. They go beyond this first steps that the European Banking Authority (EBA) and the Bank of England have already begun implementing [For example, refer to the Bank of England’s Discussion Paper, The 2021 biennial exploratory scenario on the financial risks from climate change, December 2019.]. The authors highlight emerging discussions to integrate climate-related risks in the three pillars of the Basel Framework including, for example, imposing additional capital requirements for so-called ‘brown assets’.
It remains early days, of course, but it will prove wise to keep an eye on the business implications as we could, for example, witness a change in institutional appetite to finance ‘brown assets.’ What’s more, there could be operational implications such as new data attributes that must be sourced to distinguish ‘green’ vs. ‘brown’ assets.
c) Call to Action for Board Members and Executives
When I finished reading The Green Swan, I asked myself the ‘so-what’ question.
What should our clients – Members of Boards of Directors and Executives of financial institutions – do to account for climate risks and ensure that their respective firms are equipped to deal with it from the perspective of strategy, business, operations, data, systems and, obviously, risk management.
I am still shaping my response and, admittedly, will need a lot more time for my ideas to mature. However, there are a few things I would consider.
First, they may wish to review and challenge their firm’s stance on climate risk considerations. By that I mean, are climate risk considerations integrated into the firm’s business strategy? How are they implementing their strategy and commitments? How are they monitoring their actions, including, for example, its actions to minimise their impact on the environment and transition to a low-carbon economy to meet its climate-risk commitments?
Second, they may wish to undertake an assessment of the institution’s exposure to different climate scenarios. They’d need to take physical and transition risks into account, conscious of both vulnerability and adaptive capacity. To explain what I mean, let us illustrate it with credit risk, which remains the largest balance sheet risk in banking.
Climate-related risks can give rise to credit risk. Take a bank that has lent money to two oil and gas companies. Climate-related risks could affect the ability of these oil and gas companies to repay their debts, resulting in higher probabilities of default (PD) and could result in higher loss-given-default (LGD), even for collateralised loans, as a result of some of the assets becoming ‘stranded’. These two debtors are vulnerable from a climate risk perspective. However, their sensitivity and adaptive capacity might differ significantly, as their respective exposures to transition risks may vary significantly, depending on factors such as the likelihood of owning stranded assets, or their degree of diversification into renewable energy.
This second point, assessing an institution’s exposure to climate scenarios, is of paramount importance. As the example shows, it goes beyond a 30,000-foot impact analysis evaluating the institution’s exposure to a sector (e.g., oil and gas) based on NACE/SIC codes. It requires a more granular evaluation of the risks involved. It requires data — or, at least, proxy data.
Directors and Executives ought to understand their institution’s exposure to the ‘green swan’ in terms of credit risk, market risk, liquidity risk, operational (and reputation) risk, and – in particular for the insurance and reinsurance sectors – higher than expected claim payouts.
The real work has only just begun.
Should you wish to discuss the above, do not hesitate to reach out to Gwennoline d’Avout, Senior Manager, Green Reply. She and her team assist a wide range of clients with respect to ESG and climate risk.