Central banks helped save the economy during Covid, are they coming back to save the planet?

Central banks and regulators have played a key role in maintaining confidence in financial markets and the banking system during the Covid crisis, after perhaps belatedly coming to the rescue of the financial system just a few years earlier during the global financial crisis.

Regulators may have been slow to appreciate the house of cards sprouting up from subprime mortgages; paper-thin structures of skyscraper scale constructed from Mortgage backed Securities, Collateralised Debt Obligations and Credit Default Swaps issued by systemically important banks and insurance companies. This time they are very much awake to the threat climate and stranded assets pose for financial markets and the global economy. Action is brewing, particularly in the US and Europe and regulators have the unique power to defuse the climate time-bomb nestled at the heart of our financial system, transforming global finance and banking overnight.

It could also save the planet as we know it.

Further evidence of this has come in the shape of an Financial times report that central bank consultations about to begin on how to adequately address climate risk in a coordinated way.

The FT reports;

Beginning today, central bankers from China to the US will join with Christine Lagarde and other notable economists for an unprecedented conference about “green swans” — the fear that climate change poses under-appreciated risks to economies.

France’s central bank governor Fran?ois Villeroy de Galhau stated

"it is about our operations. For me, we will have to incorporate climate-related risk in the assessment of both our collateral and our asset purchases, but focused on corporations. We have data already on their climate alignment. We should use this data to build progressively to our asset purchases on corporates and our collateral policy".

Very recently Australian Prudential Regulation Authority (APRA) launched a tender seeking "climate risk modelling" on behalf of major banks involving assessment of the impact on the sector and its biggest clients if climate change creates a 'hot house earth' with temperatures more than 3 degrees higher than current.

Australian regulators and bodies such as the Australian stock exchange (ASX) are scrutinising corporate management of climate change risk and the adequacy of their disclosure framework. APRA has been warning entities they are lagging in managing climate-related risk. Financial reporting requirements are triangulating on recommendations from the Task Force on Climate-related Financial Disclosures (TCFD) to improve and increase reporting of climate-related financial information, with the basic premise that climate change-related issues need to be measured and disclosed with the same degree of rigour as any other financial variable.

The Reserve Bank of Australia (RBA) are also warning of both the physical impacts of climate change and the transition to a less-carbon intensive world in terms of first-order economic effects. ASIC (Australia's integrated corporate, markets, financial services and consumer credit regulator) "considers that the law requires an operating and financial review to include a discussion of climate risk when it is a material risk that could affect the company’s achievement of its financial performance". Recent legal judgements also underline directors’ duties and notes the potential liability of directors in relation to climate change is increasing exponentially.

So even in Australia, widely regarded as a global laggard on climate action, there are no shortage of warnings coming from regulators about the liability in refusing to acknowledge and manage climate risk and to ensure adequate disclosure relating to material risks from climate change. Recent court decisions directing action to address climate risk such as that against Shell and the Federal court decision affirming that the Australian Government Environment Minister has a duty of care to young people, are significant steps forward.

The Federal Court of Australia determined that the Federal Environment Minister

"has a duty to take reasonable care not to cause the Children personal injury when exercising her power under s 130 and s 133 of the EPBC Act".

In assessing that harm , Justice Bromberg explicitly contemplated the "hothouse earth" scenario;

"Those potential harms may fairly be described as catastrophic, particularly should global average surface temperatures rise to and exceed 3°C beyond the pre-industrial level. Perhaps the most startling of the potential harms demonstrated by the evidence before the Court, is that one million of today’s Australian children are expected to suffer at least one heat-stress episode serious enough to require acute care in a hospital. Many thousands will suffer premature death from heat-stress or bushfire smoke. Substantial economic loss and property damage will be experienced. The Great Barrier Reef and most of Australia’s eastern eucalypt forests will no longer exist due to repeated, severe bushfires".

Harms that stems from

"the inaction of this generation of adults, in what might fairly be described as the greatest inter-generational injustice ever inflicted by one generation of humans upon the next".

Despite the unusually forthright language in this decision and increased frequency of success for climate activists at court, the well trodden playbook in the past has been endless legal appeals and willful neglect of duties, chewing into the precious little time left to avoid gut-wrenching system change.

Disclosure and liability for action are inevitable and irresistible forces for long term change but represent a "slow-burn" approach to regulating financial system risk, particularly when a new analysis from DeSmog finds that 77% of board directors at the top-7 US banks have ties to “climate-conflicted” groups. Shareholder activism is making progress as witnessed by resolutions and board appointments at major energy companies such as Exxon and Chevron in recent months, but again is a "let the system run its course" approach.

However, regulators as an "engine" of change could be on the verge of becoming "electric".

In the US, it was recently reported by Politico that a draft executive order titled “Climate-Related Financial Risk," directs White House economic and climate advisers to

"work with the Office of Management and Budget on a government-wide strategy to measure, mitigate and disclose climate risks facing federal agencies. Banking, housing and agriculture regulators are among those that will be asked to incorporate climate risk into their supervision of major industries and the lending of federal funds". The order directs Janet Yellen, as head of the Financial Stability Oversight Council (FSOC), to "assess risks to the financial system and the U.S. itself and deliver a report within 180 days. The council, established after the 2008 Wall Street meltdown, includes the heads of all the federal financial regulators. Banks, asset managers, insurers and others in the financial services industry stand to be affected by any FSOC action".

In a excellent and informative podcast by The Energy Gang at Greentech Media, Justin Guay, Director Global Climate Strategy Sunrise Project notes that in relation to addressing risks to the financial system, the FSOC have almost "biblical powers".

Of particular interest to bond investors like Altius Asset Management is consideration of the threats to the stability of the system from a concentration of lending to fossil fuel companies by parts of the banking sector. Regulators have a long history of prudential controls to head off speculative activity threatening system stability.

European, UK, Australia and other developed market central banks utilise a wide range of macroprudential tools that have had success in tackling systemic risks and asset bubbles. They include limits to sectoral concentration, such as capping a banks’ exposure to certain industries, or on conditions of lending such as loan type, loan to valuation ratios and loan to income ratios.

Generally speaking, the U.S. does not utilise macroprudential tools as much as other countries. The Fed’s macro policy settings were born of the GFC. The Fed as the bank holding company regulator applies the Globally Systemically Important Bank capital charges and assesses the level of the Countercyclical Capital Buffer consistent with international Basel III capital requirements. The Fed conducts annual stress tests of the largest bank holding companies which incorporate some macroprudential elements, such as scenarios designed to address system-wide financial risks. It can use these capital charges to enable or hinder the ability for banks to offer credit, as evidenced recently when it provided capital and liquidity relief to banks to cater for the inevitable delinquent loans associated with Coronavirus related business closures. 

In Australia, APRA introduced such measures in 2017, building on measures introduced in 2015 in response to an environment of heightened risks in lending for residential property (high prices, elevated and rising household indebtedness and slowing household income).

Direct controls were enacted which;

• limited new interest-only lending to 30% of total new residential mortgage lending, and demanded strict internal limits on the volume of interest-only lending at loan-to-value ratios (LVRs) above 80%; and ensure there is strong scrutiny and justification of any instances of interest-only lending at an LVR above 90%;
• required management of lending to investors so as to comfortably remain below an advisory benchmark of 10 per cent growth;
• required a review of serviceability metrics, including interest rate and net income buffers, to ensure they are set at appropriate levels for current conditions; and
• restrained lending growth in higher risk segments of the portfolio (e.g. high loan-to-income loans, high LVR loans, and long term loans).

The FSOC plan for addressing climate risks facing the financial system will of necessity address "speculative excesses" related in particular to continued financing for new Oil and Gas projects without regard to whether the resource can ever be fully exploited due to the likelihood of future global emission reduction targets (noting that Coal has become almost unbankable all by itself). The action plan could include such direct lending controls or "credit guidance" such as employed by APRA and other regulators/central banks in the past. Collateral rules at the Federal Reserve could apply haircuts to securities issued by fossil fuel companies or even exclude them altogether. Alternatively regulators could require additional capital charges in aggregate or against lending concentration to the fossil fuel sector.

In a surprisingly concerted fashion regulators, central banks, shareholders and the courts are beginning to sing the same tune. The mere contemplation of a "hothouse earth" scenario is confronting. It can also be energising. Financial regulation may be one of the most effective weapons available to us and could drive far-reaching change at a speed climate negotiators could only dream of.

Bill Bovingdon - Chief Investment Officer Altius