This is the personal website of Mark Cliffe, Visiting Professor at the London Institute of Banking & Finance, Board Advisor, Economic Consultant and former Chief Economist of the ING Group.
The US Federal Reserve’s new pilot climate scenario exercise for major US banks is likely to understate both the risks and opportunities of tackling climate change.
The US Federal Reserve is being dangerously complacent about climate change. It understandably does not want to take the lead on an issue that remains so politically polarizing in the United States. But its newly announced climate scenario exercise with six major banks is set to woefully understate the risks and opportunities offered by the transition to net-zero emissions. In the process, it will do little to foster the ambition to tackle climate change shown in the Biden Administration’s landmark Inflation Reduction Act.
Having failed to absorb the lessons from similar exercises by central banks in Europe and elsewhere, the Fed is relying on scenarios created by the Network for Greening the Financial System (NFGS), despite a growing recognition that these rest on flawed foundations.
Central banks have long conceded that crucial risks are missing from the mainstream integrated assessment models (IAMs) that they use. Yet they fail to admit that these gaps leave their analyses systematically biased against climate action. They have ignored trenchant critiques from eminent economists such as Nicholas Stern and Joseph E. Stiglitz, who note that “IAMs have very limited value … They fail to provide much in the way of useful guidance, either for the intensity of action, or for the policies that deliver the desired outcomes.”
The increasing frequency and severity of extreme weather events is now too obvious for central banks to ignore. Yet while the Fed’s exercise will include a scenario in which a major hurricane hits the US East Coast, its NGFS-style modelling will omit many critical factors and processes. Disruptive shifts in politics, policy, financial markets, and technology will all be glossed over. The complex interactions between climate-driven events and human behaviour, involving tipping points and non-linear changes or discrete jumps in climate-risk probabilities – will barely be captured.
This means that possibilities such as a prolonged war in Ukraine, a return of White House climate denialism, a renewables trade war with China, recessions, or stock-market crashes are nowhere to seen. Nor are more positive possibilities, such as a surge in the popularity of progressive green politics, an explosion in electric-vehicles sales as they reach price parity with internal combustion engine vehicles, or continued rapid technological progress.
Far from being mere technical details, these kinds of modelling flaws could lead to disaster. The NGFS scenarios would have us believe that in a “business as usual world” heading to 3° Celsius warming, global GDP in 2050 would be only around 4% lower (implying a loss of less than two year’s growth) than in a world where we have achieved net-zero emissions and kept warming within 1.5°C. No wonder central banks foresee only modest financial losses. Yet this outlook contrasts starkly with climate scientists’ frantic warnings about the enormous damage that continued global warming will do.
Compounding the problem, the NGFS scenarios downplay the potential benefits of the net-zero transition. In fact, they suggest that it will lead to higher inflation and lower growth, while ignoring the possibility that green technological progress will lower prices and boost growth.
This brings us to another problem with the Fed’s climate-scenario exercise: It will do little to help banks meet the NGFS’s own call for them to consider climate risks and opportunities in all their decision-making. Banks in Europe have already cast doubt on the usefulness of their local supervisory exercises, and a similar reaction is likely in the US. Scenarios that are woefully inadequate for assessing long-term systemic risk obviously are even less useful for stress-testing specific banks.
Having issued their own net-zero pledges, banks are under more immediate pressure to develop and execute their transition plans. Many have already committed to interim targets such as halving the emissions that they are financing by 2030, implying reductions of 8% per year. Such robust changes will transform their strategies, business models, and credit and investment decisions.
These developments ought to force a radical shift in climate-scenario analyses. There is a glaring need not only for more realistic long-term scenarios, but also for more suitable short-term and bespoke scenarios. These would be profoundly different from the NGFS scenarios. But, again, the Fed seems not to have gotten the memo. Although it has shortened the time horizon for its exercise from 2050 to 2032, it is sticking with the NGFS.
This makes little sense. For scenarios extending less than ten years, global warming is not a risk; it is a near certainty. The crucial uncertainties are those stemming from extreme weather events and transition risks involving the interplay of geopolitics, local climate policies, and financial-market volatility. True, the NGFS has announced plans to address this gap by developing short-term scenarios. But it remains to be seen whether these will be able to meet banks’ immediate needs. Most likely, banks in the US and elsewhere will be forced to take the initiative themselves.
But this points to another problem with the Fed’s incremental approach. More bespoke scenarios will shift the focus toward banks’ own risks, and away from those of the broader system. Individual banks are concerned not just with their own climate footprints and supply chains, but also with the behaviour of their competitors (and hence their relative performance). While banks certainly run a risk in “going green” too slowly, they may also face a risk of moving too fast, because if everyone else fails to meet their net-zero goals, their green loans and investments may turn out to be loss-making.
The Fed deserves credit for putting climate-scenario analysis on the agenda. But in prescribing scenarios that fail to capture the realities of climate change, it risks distracting banks from the urgent task of reallocating capital flows. The world can ill afford another lost year in the pursuit of Net Zero.
Back in April 2020, only a few weeks into the Covid-19 pandemic, I published a report entitled “Pandenomics – 15 Ways that Covid-19 could change the world”, with a subsequent spinoff for the CEPR’s VoxEU. Now that the pandemic is thankfully in retreat, I was delighted to be invited by Gabriel O’Brien of Chief Disruptor Live on a podcast (link here) to take stock of these themes.
In the podcast I outline how they are still playing themselves out, with the global disruption from Russia’s invasion of the Ukraine giving them additional spin. We discuss the evolving role of big government, deglobalisation, and technology. An overarching theme is the need to go beyond traditional data-driven risk management techniques to navigate radical uncertainty.
Why increasing volatility in the weather has more immediate impact than global warming
Source: rmets.org
Scientists have long warned that climate change will adversely affect weather patterns and living conditions around the world. These warnings are turning into a painful reality. Worse, the range of possible outcomes is becoming increasingly “fat tailed”: extreme weather events such as heatwaves, severe storms, and floods are more likely than normal statistical distributions would predict.
None of this bodes well for future political stability or economic prosperity. Our best hope is that the sharp sting in these tails will goad us into the necessary remedial action before things get even worse. But will it?
The public is increasingly aware that global warming is leading to more volatile weather. There have been record-setting heatwaves around the world this year, not just in India – where temperatures reached 49.2°C (120.5°F) – but also in places like the United Kingdom (40.2°C). France and China are experiencing their worst droughts on record, and four consecutive years of failed rainy seasons in Eastern Africa have put more than 50 million people at risk of “acute food insecurity.” Meanwhile, devastating storms and floods have hit Madagascar, Australia, the United States, Germany, Bangladesh, and South Africa.
This rising volatility in the weather is crucial. Short term weather fluctuations often have a much bigger impact than longer term trends. While temperature increases of 0.5°C here or there are barely perceptible, droughts, floods, and other short-term weather fluctuations can wreak deadly havoc. These events cause hundreds of thousands of deaths and enormous economic and financial damage each year.
Moreover, extreme weather events can cause changes that last far beyond the immediate shock and damage. Crucially, they can accelerate developments that might otherwise take many years. Scientists are increasingly worried about “tipping points” – such as the melting of polar ice sheets – that would carry us across thresholds of irreversible change. This could create damaging feedback loops between interconnected climate risks, all of which would spill over into the real economy, driving defaults, job losses that disproportionately harm disadvantaged communities, and political turmoil.
Aside from the damage to the physical environment, extreme weather may therefore trigger abrupt and sometimes permanent shifts in social attitudes and public policy. When people start losing their homes, livelihoods, or even their lives, politicians must respond.
Surprisingly, while we are all acutely conscious of extreme weather, forecasters still widely overlook its role in accelerating structural changes. Mainstream climate scientists and economists tend to focus on the longer-term effects of climate change brought about by global warming, with an emphasis on scenarios involving global average temperature increases in the range of only 1.5°C-2°C – the targets enshrined in the Paris climate agreement. And even in higher-temperature scenarios, it is assumed that the effects – on sea levels and agricultural output, for example – will accumulate only gradually, implying that the ultimate reckoning is several decades away.
But a recent paper – “Climate Endgame: Exploring Catastrophic Climate Change Scenarios” – shows that this conventional scenario analysis gravely understates the long-term risks, because it fails to give the more extreme climate outcomes (the fat tails) the attention they deserve. As the statistician Nassim Taleb has pointed out in the context of financial markets, conventional models struggle to handle the consequences of fat-tail events, creating a dangerous blind spot in their outlook.
Cascading Global Climate Failure
Source: Climate Endgame: Exploring catastrophic climate change scenarios – Kemp et al 2022
Higher temperature pathways would unleash what the authors call the “four horsemen” of the climate endgame: famine and malnutrition, extreme weather, conflict, and vector-borne diseases. It does not take much imagination to see how this herd of apocalyptic harbingers might create social and political chaos, especially when they are all galloping together – as is already the case today with the global food crisis, war in Europe, and the ongoing pandemic.
Worse, the mention of the second horseman, extreme weather, suggests that the more immediate risks of climate change are still being underplayed. After all, extreme weather is also a driver of the other three horsemen, making it arguably the most important.
And crucially, it is already with us. Weather shocks cause suffering that grabs society’s attention far more than abstract (though no less warranted) warnings of long-term doom. Polls show that support for climate action is greater for those who have personally experienced extreme weather. Although the current upsurge in inflation means that people are less enthusiastic about measures that would hurt their own finances, the growing incidence of disasters is shrinking the minority that remains skeptical of climate change.
In this way, the fat tails of the weather – rather than the fat tails of long-term climate change – are far more likely to prompt action within the shorter time horizons that preoccupy politicians and business. That at least is the hope that should sustain us as the stings from these tails become ever more common and painful.
Extreme weather events are becoming bigger and more frequent
There is no doubt that the central banks, supervisors and regulators recognise the urgency of climate change. This is why they are conducting stress tests on the financial risks that it poses to the banks and other financial institutions. Sadly, the signs are that the scenarios that they have so far provided for this purpose will not be stressful or shocking enough to make much difference the financial institutions’ behaviour. Perhaps inadvertently, they risk fostering complacency.
I was privileged to be invited to address this in an article for Environmental Affairs, Policy Exchange’s quarterly policy journal, published just ahead of the COP26 climate talks in Glasgow. In it I note that despite the central banks’ humility about their current modelling, their scenarios suggest that climate risk will make little difference to growth or financial losses even on a 30 year horizon.
In the ECB’s case, the cumulative total difference in GDP between their business-as-usual ‘hot house’ scenario and an orderly policy ‘Net Zero’ scenario is barely 3%. This is despite escalating physical risks and the dramatic transformation in the economy that decarbonisation will entail. This modest range of variation is against the basic essence of the scenario method, which is to explore a wide enough range of possibilities to provide strategic insights.
If the central banks wish to inject the needed urgency into the financial institutions’ embrace of climate risk the next phases of their stress testing exercises will have to rise to the challenge set by the BIS for an ‘epistemological rupture’. There are four ingredients that could feed into the rethink required; their scenarios should:
1. Focus on shorter time horizons in line with traditional solvency stress tests and the planning horizons of the financial institutions. Most of them are already signed up to being ‘Net Zero’ by 2050, so the challenge is to operationalise this now and to recognise that the financial risks and opportunities are far larger and more immediate than the central bank scenarios suggest. The ECB’s latest announcement that next year’s stress test will incorporate policy and weather shocks in 2022 is therefore a welcome step forward.
2. Stop ignoring or downplaying crucial risks. Extreme weather events, political disruptions, policy shifts, financial markets, behavioural and technological change are all aspects that are difficult to calibrate and model. But failing to account for them severely reduces the realism and useful of the scenarios for stress testing purposes.
3. Recognise that non-linear dynamicswill accelerate change, for good or ill, making the likelihood of extreme outcomes far more likely. The central banks’ models yield smooth orderly changes and fail to capture the risk that the climate may breach thresholds beyond which damages may accelerate and become irreversible or existential. Socio-political disruptions, policy shifts and market spikes and crashes could all feature in more illuminating short term scenarios.
4. Adopt a systemic approach to factor in the complex interactions between the drivers and impacts of climate change. Earth systems and the economic, financial, political and social systems are interdependent in a way that can lead to powerful feedbacks. This adds layers of uncertainty which argues for embracing the ‘precautionary principle’ by making assumptions that result in a broader range of outcomes.
A prime illustration of the problem is that the central banks’ scenarios start from the same economic growth baseline, even though it is obvious that different growth rates and cycles would dramatically alter the evolution of climate risks. What makes this particularly odd is that macroeconomic shocks are at the heart of traditional stress testing exercises.
But the scenario method provides room to develop plausible narratives to address these complexities. The pandemic has provided a timely lesson in how nature can trigger rapid changes in human behaviour, whether it be politics and policy, markets and innovation, or social norms and consumer behaviour. In the case of climate change, official forecasts continue to underplay the fact that the costs of renewables are falling, partly through policy support, in a way that is triggering tipping points in business and consumer demand.
On the flipside, the central banks also understate how policy inertia or missteps could crystallise longer term financial risks from stranded fossil fuel assets and labour well before 2030, let alone 2050. It is time to inject some real stress into their climate stress tests.
Where’s the beef? Cutting consumption to cut carbon
Source: Gianluca Milanesi (Unsplash)
Here’s a link to the podcast of my interview by Gavin McLoughlin of Newstalk radio on “Reducing Consumption and Committing to Decarbonisation”. It was a broad-ranging conversation, touching on spending patterns, lifestyles, jobs, innovation and policy. We began by discussing the rise of meat and dairy alternatives – here are some of my key points:
The rapid growth in meat and dairy alternatives:
“Governments around the world are setting even more ambitious goals in terms of climate change, and agriculture is part of that story, so it’s not just about people’s changing diets it’s also about the warming of the planet”
“over time as more and more consumers make the switch that’s going to increase the volumes. That in itself will reduce the cost of these alternatives [and] there’s a huge amount of money going into innovation in this area which will also reduce the cost”
“this is a rapidly growing and profitable area and [producers are] going to give the consumers a further push by marketing these alternatives more aggressively”
“ the growing middle class in particular in Asia sees things like meat and indeed dairy products as aspirational products […] this is a little unfortunate when we’re trying to reduce things like methane emissions from cattle”
“it’s extremely important that we put rocket boosters in under some of these changes and we head off [..] the changes in people’s consumption habits right across the world but particularly in Asia”
“another lever here […] could be regulations which may well be focused on trying to encourage farmers to come up with methods that reduce the amount of methane that’s being produced”
“another part of [the policy response] is the dreaded ‘t’ word, which is tax. We could see some kind of luxury tax be eventually being imposed on some food items”
“historically this has been a bit of a ‘no-no’ because of course it’s something which is seen as particularly hurting the poor. But there [is a way to tackle] that problem which is to redistribute some of the tax revenues that you get from taxing for example on meat and dairy products and using that to reduce taxes particularly on poorer households to compensate them”
The cross-border challenges
“there are two different things going on here on the what one is what’s happening to consumption and the other is the competitive aspect of production. You we see this in some of the very tetchy sort of trade negotiations that we’ve had in the last few years”
“this is going to be a messy process but you have to hope that the politicians who will be getting together in the coming months on these topics will start to address these problems head on”
“there will need to be some kind of agreement amongst the developed nations to effectively transfer funds to the emerging world to help them in this transition, otherwise this is going to be a very protracted and painful process.”
The impact on jobs
“Policymakers have really got to take care of the people of losing out in this transition not just on the consumer side, poorer households who might be facing bigger bills, but also on the jobs side”
“they will have to start putting money into, for example, disadvantaged parts of agriculture [such as] the idea of paying people to conserve nature”
“this kind of stuff can’t happen just overnight you’re going to have to phase in some of these changes”
“an important principle […] is you need to front run the compensation. In other words, you need to start anticipating the people who are going to lose out in this transition and put a lot of policy energy into thinking about how you can take care of those people”
Restraining consumption
“Consumption patterns will have to change and the sad fact is and this is not an easy message for politicians to get across”.
“we can’t expect to live our lives in the way that we have in the past. We are just consuming too much stuff”
“we can’t have the planet aspiring to running around in two and a half tonne SUVs even if they are electric”
“we’re going to have to look at other policy measures which are pretty radical so, for example, let’s take cars again I think you could anticipate that eventually there’s going to be much higher taxation on bigger cars”
“we need to get into position where the default position is actually I just need a vehicle that’s fit for purpose. Because the vast majority of people are travelling around either on their own or with just one passenger and for most journeys a small vehicle is perfectly adequate. If anybody wants to use a big vehicle for longer trips they’re just going to have to start thinking about renting them”
“ we’re going to have to start thinking about lifestyle changes as well there’s no way around the fact that lives will be transformed by the decarbonization”
Green credits
“the idea here is because you could be generating quite a lot of revenue from these taxes why not start to compensate some of the people are losing out in this transition by giving people flat rate credits up front”
“poorer households in essence would potentially be net beneficiaries from this package because the flat rate credits would be worth more to them than it would be to richer households who obviously consume a lot more of goods and bigger houses and other things that would be subjected to much heavier taxation over time”
“it’s not something that could happen overnight it would have to be phased in and there be obviously a huge amount of fuss about this, but the good news is I think we’re beginning to see people change their attitudes”
Will it happen?
“I’ve putting these ideas forward just to try and provoke debate and hopefully get people to tune into the idea that there are radical policy measures that could be enacted”
“it is no good NGOs just pointing the fingers at business. Business has got its part to play for sure but in the first instance it’s a case of market failure where policy needs to change”
“…whether that’s regulation or taxes and subsidies or massive public investment that has to happen in a big way over the next few years”
“the longer we leave it the bigger the challenge will become”
My video contribution to the Royal Society’s #2050challenge for #NetZero argues the case for green credits to ease the way for progressive consumer taxes on resource-intensive goods.
We need to do more than decarbonise: we are over-exploiting the earth’s resources in general. We need to give up on the idea that we can tackle this without tackling the world’s growing demand for ‘stuff’. The good news is that curbing resource use would also accelerate progress towards Net Zero, by reducing embedded energy usage and the scale of capital investment needed to decarbonise the world economy.
Like any tax, progressive consumption taxes would also face resistance. But since many governments are not in immediate need of more tax revenue, and can borrow cheaply, the prospect of higher green taxes could be made more palatable by giving everyone equal ‘green credits’ upfront. And since these equal payments would disproportionately help the poor, the package would be seen as fair.
Only later would the green taxes be phased in, and green credits could be used to pay them. The taxes would also be designed to fall more heavily on the rich, meaning that after allowing for the credits, poorer households would be both absolutely and relatively better off.
The rich account for a disproportionate share of consumption of energy and resource intensive goods, and green consumption taxes could be made even more progressive by relating them to the size and weight of goods and homes. So for example, by taxing big cars at a much higher rate, say by an extra 10% on purchase and with premium fees for usage, the rich would be hit a lot harder. This would encourage people to buy smaller, less resource intensive items, or share them, or generally switch their spending towards services.
My “Stuff Stuff” article argued that if we are to save the planet “we cannot and should not aspire to every household in the world owning a 2½ ton SUV”. Cars are an emblematic and critical illustration of our need not just to decarbonize but dematerialize economic activity. Electrification and energy efficiency is not enough. We have to do more to curb demand growth to help curb our net usage of resources.
This does not mean that we are going to have to ban cars and just use public transport, ride bikes and scooters or simply walk. Electric vehicles will undoubtedly help. But they would help a lot more if we weaned ourselves away from the American-led passion for big cars (see my response to Noah Smith’s post on this topic). I address this in a follow up piece to “Stuff Stuff” for Jackson Hole Economics, entitled “Making Small Cool”.
Ford F Series Pick Up
Take the comparison between the US and Japan. In the US, the best selling ‘cars’ are actually huge pick-ups like the Ford F Series, Chevrolet Silverado and the Dodge Ram. It is easily forgotten that a catalyst for the US – and increasingly global – mania for pick-ups and SUVs was successful auto industry lobbying for laxer emissions standards on light trucks back in the 1970s. ‘Shifting the metal’ marketing did the rest.
Honda S660
By contrast, the best selling cars in Japan are micro ‘kei’ cars such as the Honda N box and cooler variants such as the S660 roadster. These cars are less than half the size and weight, and a third of the price, of the US bestsellers. Again, government action, in the form of lower taxes and exemptions for kei cars, has been critical in shaping this.
Europe, where the best selling car is the VW Golf, leans more towards Japan than the US, but it has nevertheless caught the SUV bug over the last few years. Environmentalists are now fighting this bug (see here), and social pressures might start a shift in marketing fashion towards smaller cars. But progressive taxes on the purchase, usage and disposal of larger cars could radically accelerate this. And as I will argue in forthcoming posts, they would also serve to address the massive underutilisation of the existing car fleet and to replace the loss of fossil fuel tax revenues as electric vehicles take over. Making small cars cool could help us win the ‘Race to Zero’.
We are consuming too much stuff. This is not just bad for the planet, it’s bad for our prosperity and happiness. As we look to recover from the Covid-19 pandemic and tackle not just climate change but broader environmental damage, this is a good moment to tackle this. Ramping up progressive taxes on goods – the bigger the car, the bigger the house, the bigger the tax – would fall on the rich more than the poor. The proceeds could be used to support jobs and services that would leave us all better off.
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“we clearly cannot and should not aspire to a world in which every household inhabits a mansion and owns a two-and-a-half-ton SUV”
Crucially, the revenue potential for new green taxation is enormous. In the OECD countries, green taxes raised only the equivalent of 1.6% of GDP in 2014, and have been flat or declining for many years. Ramping this up would be a smart way to ‘Bill Back Better’ to pay for ‘Build Back Better’.
Leaving in the midst of the Covid-19 pandemic lockdown is somehow fittingly strange and unexpected. My 22 years at ING, mostly as Chief Economist, marked an unforgettable period of shocks in economics, politics, technology, society and, increasingly, the environment. The thread running through this is what I like to call the New Abnormal. This is a world which is structurally in a state of flux, which consistently defies attempts to define a return to a ‘new normal’. When some start talking of the ‘next normal’, you know that hopes for a comforting period of stability are on shaky ground.
This line of thinking lies behind my longstanding humility about what I called my ‘day job’: macroeconomic forecasting. I provided a critique in my post entitled ‘Confessions of an Economic Forecaster’ . If anything, the social, digital and environmental transformations that we are going through intensify the fundamental problems for macro-economic forecasting, at least as it commonly practiced. Looking ahead, I’m going to continue to explore the implications of these transformations. And for that, I’m keen to keep drawing on a diverse range of experts and sources.
The coming year will be critical in setting the direction for what is widely seen as the ‘decisive decade’ for action on climate change and the UN’s Sustainable Development Goals (SDGs).
Thankfully, contrary to earlier fears that climate action would fall victim to the Covid-19 pandemic, governments and corporates are instead strengthening their commitments to net zero. News that the EU increased its emissions reduction target for 2030, from 40% to 55%, has been followed by a pledge from China to aim for net-zero carbon dioxide emissions by 2060 and from Japan and South Korea by 2050. Meanwhile, the election of Joe Biden as US President is boosting hopes that the COP26 climate talks next November will lead to accelerating progress.
Key dates for climate policy
Dec 12 Global Climate Summit (UN/UK)
Jan 5 Georgia Senate Runoffs (will determine control of the US Senate)
Jan 25 Climate adaptation summit (Netherlands)
March China’s 5 Year Plan and Vision, 2035 outline
Q2 US Budget approval under new Administration
Q2 EU legislation on 2030 “Fit for 55 Package“ and sustainable finance
TBD G20 Summit Italy
H2 IPCC Climate Change reports on Mitigation (Jul) and Adaptation (Oct)
Nov 1-12 COP26 negotiations, Glasgow UK
Q4 EU draft legislation on circular economy
One reason why climate action has fresh momentum is that policy-makers are folding it into their efforts to achieve a ‘just transition’ and ‘build back better’ by addressing social inequality and broader environmental goals. The pandemic is highlighting the connections between people and the planet. Indeed, that’s why the SDGs are presented as being indivisible.
This was the theme of the sustainability panel entitled ‘Building Back Greener and Better’* at the recent Institute of International Finance (IIF) Annual Members Meeting, which I had the privilege to moderate. The expert panel included Ben Caldecott (Oxford University), Elsa Polanza (Barclays) and Emmanuel Martinez (SocGen). It struck an optimistic note on the prospects for action from policy-makers, corporates and financial institutions in the coming year.
The video of the webinar is now available for viewing on YouTube
Mark Cliffe 