London — Climate change could trigger the next systemic financial crisis, calling into question the role of central banks in reducing risks, the Bank for International Settlements warned in a report.
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That's because limiting global warming to less than 1.5 degrees Celsius requires keeping a large proportion of existing fossil fuel reserves in the ground -- creating potential risks for the valuation of fossil fuel production companies and the wider financial system.
"As the risk related to stranded assets is not reflected in the value of the companies that extract, distribute and rely on these fossil fuels, these assets may suffer from unanticipated and sudden writedowns, devaluations or conversion to liabilities," BIS said in the report released Monday.
Taking a wait-and-see approach to climate change could prevent central banks from fulfilling their mandate to deliver financial stability, but nor can they step in to replace action by governments or private actors, leaving them playing a role as coordinators between other organizations, it said.
"Exceeding climate tipping points could lead to catastrophic and irreversible impacts that would make quantifying financial damages impossible," BIS said in the report.
"Avoiding this requires immediate and ambitious action towards a structural transformation of our economies, involving technological innovations that can be scaled but also major changes in regulations and social norms," it said.
Based in Basel, Switzerland, BIS is an international financial institution owned by central banks which supports financial stability and cooperation between them.
BIS warned that climate change could lead to "green swan" events -- climate-related physical and transition risks which involve interacting, nonlinear and fundamentally unpredictable environmental, social, economic and geopolitical dynamics that are irreversibly transformed by the build-up of greenhouse gases in the atmosphere.
In particular, BIS warned that climate change could trigger risks for which the chances of occurrence are not reflected in past data.
"In this context, traditional approaches to risk management consisting in extrapolating historical data and on assumptions of normal distributions are largely irrelevant to assess future climate-related risks," it said.
Energy transition inherently unpredictable
The energy transition required to avert the worst climate impacts is inherently unpredictable, BIS said in the report, making forecasts of future energy and technology trends difficult.
As an example, the sharp increase of usage and cost variation in many renewable energy technologies over the past few years has outpaced most predictions, and this seems to have responded more to massive investments in R&D and targeted subsidies to solar energy than to any ambitious carbon pricing mechanism, it said.
In contrast, the intermittency of renewable energy remains a considerable problem that tends to be overlooked, it said.
"Moreover, other sectors may be impossible to decarbonize in the medium term regardless of carbon pricing, as we can observe (so far) not only with aviation or cement, but also parts of the energy sector," BIS said.
"In short, the type of technological solution that will prevail in a low-carbon world is largely unpredictable. A case in point is the transportation sector: the most promising technological alternatives have varied greatly over short time horizons and with new technologies such as hydrogen fuel," it said.
Banks could help coordinate action
Climate change therefore puts central banks in an awkward position, BIS said.
On the one hand, central banks have a role to play in avoiding potentially extremely financially disruptive events. On the other, central banks alone cannot mitigate climate change or fulfil the role of governments, it said.
"Pursuing the current trends could leave central banks in the position of 'climate rescuers of last resort,' which would become untenable given that there is little that monetary and financial flows can do against the irreversible impacts of climate change," it said.
"In other words, a new global financial crisis triggered by climate change would render central banks and financial supervisors powerless," it said.
As a complex collective action problem, climate change requires coordinating actions among many players, including governments, the private sector, civil society and the international community, BIS said.
As part of that framework, central banks could help provide clarity on climate risks; call for bolder action aimed at resilience of natural systems as a prerequisite for financial stability; and contribute to managing those risks within the remit of evolving mandates provided by society, it said.