AMSTERDAM – When forced to explain why so few anticipated the global financial crisis, former US Federal Reserve Chairman Alan Greenspan blamed “animal spirits,” investors’ herding behavior, unimaginably large tail risks, and black swan events. In other words, he absolved the money managers and financial institutions that had been taking massive risks on the assumption that overvalued assets could be passed on to less-informed market actors, their own shareholders, and, ultimately, taxpayers.
When it comes time for global leaders to defend their decades of inaction on climate change, which is set to trigger an environmental and economic crisis on an unprecedented scale, their defense may well look a lot like Greenspan’s. And it will be just as unconvincing.
The hope, of course, is that world leaders wake up to the threat in time to address it. This will require, first and foremost, a massive push by policymakers to reduce greenhouse-gas emissions over the next 15 years. At the same time, investors and businesses will have to adjust to the new policy environment by disentangling themselves from carbon-intensive assets.
With climate experts and the general public largely convinced that global warming is real, it is virtually impossible for opponents of action on climate change to deny the problem outright. Instead, they increasingly argue that its effects will be modest (and even positive for some); that the market is best equipped to address this historic challenge; and that policy-based solutions might well exacerbate the problem.
This position is exemplified in ExxonMobil’s recent assertion, in response to shareholder concerns, that there is no risk that its carbon-rich assets will become “stranded” (reduced in value as their market disappears), owing to the combined effects of clean-technology adoption and policies that increase the price of CO2 emissions. According to ExxonMobil, politicians simply will not risk losing voter support by implementing policies that significantly increase energy prices, especially given rising demand for energy.
This approach bears a disturbing resemblance to that taken by major financial institutions in the run-up to the crisis. Citibank’s former CEO Chuck Prince, for example, famously declared that, “As long as the music is playing, you’ve got to get up and dance.”
For ExxonMobil, the music will stop as abruptly as it did for Citibank. Indeed, policy responses to environmental challenges and the declining costs of clean-energy technologies could significantly reduce the value of up to $27 trillion in carbon-intensive financial assets. And recent research by the Carbon Tracker Initiative indicates that $1.1 trillion in high-cost oil assets are particularly vulnerable.
In fact, the shift away from such assets is already beginning. Stanford University recently decided to stop investing in coal companies – a move that could spur other institutions to respond to burgeoning student-led campaigns aimed at convincing their universities to divest from fossil-fuel companies. Moreover, FTSE Group, BlackRock, and the Natural Resources Defense Council have launched a new index series aimed at steering investors away from companies linked to the exploration, ownership, or extraction of carbon-based fossil-fuel reserves.
The coal industry is not safe even in China, the world’s largest CO2 emitter and a leading source of demand for fossil fuels. Over the last two years, policy action to address air pollution and water scarcity, together with slowing economic growth and declining clean-technology prices, have caused the share prices of major Chinese coal companies to decline by more than 40%.
An acceleration of these trends, the price-lowering effects of shale gas, and more unexpected environmental disasters like the Fukushima nuclear accident and Hurricane Sandy would trigger a sudden increase in risk aversion among investors, causing prices of carbon-intensive assets to plummet. The damage that this would do to institutional investors’ portfolios would threaten the future income streams of hundreds of millions of pension and insurance-policy holders, and ultimately undermine consumption, economic growth, investment, and employment.
In such a nightmare scenario, governments would probably try to save the day, bailing out the financial community in order to sustain growth and placate their citizens. But, in doing so, governments would effectively be transferring private-sector liabilities to their citizens, placing a heavy burden on future generations.
This outcome closely resembles that of the global financial crisis. But there is one key difference: delayed action on climate change is hastening the deterioration of the natural environment on which humanity depends. At the very least, this amounts to an irreversible drag on the global economy.
Instead of sleepwalking into another crisis, financial markets should take action to support the real economy’s long-term health, acting as stewards of the natural environment, while working to counter the blight of endemic inequality. Building a sustainable financial system does not require “green policies” so much as efforts to raise accounting and reporting standards, eliminate perverse remuneration-based and fiscal incentives, and improve risk modeling and credit ratings.
At the same time, a more comprehensive approach to governance is needed, based on a broader interpretation of fiduciary responsibility and more far-reaching macro-prudential mandates for central banks and financial regulators.
The instability engendered by humanity’s unsustainable exploitation of the natural environment is now embedded in the world’s collective store of financial capital. Without urgent action, another global financial crisis will become inevitable – with even more devastating consequences than the last.
Retrospective justifications of inaction rarely sound credible. Let us hope that the Greenspan defense is never heard again.