Green swans: Why climate change is unlike any other financial risk

Before diving into the implications of climate change as the new form of “black swan” event, we need to reflect on the complex channels by which climate-related financial risk can be identified. What is apparent is that predicting the timing and scale of these risks is profoundly challenging.

The Bank of England, in its 2017 Response to climate change, addresses the now well understood categories of climate-related financial risks – transition and physical. 

Understanding transition and physical risks

Transition risks impact companies in numerous economic sectors through shifting climate policy and technological disruption manifesting in both impacts on profits and change in valuations. 

Physical risks are associated with extreme and chronic climate shifts affecting physical assets by way of both lower asset valuation and productivity. 

Overlaying this, financial institutions, such as banks, institutional investors and insurers, are exposed to firms in sectors affected by transition, while physical risk is observed in higher insurance claims, portfolio losses, sentiment shocks and defaults on loans; each individually and collectively impacting financial stability.

These insights have universal application, transcending global, national, regional, sectoral and individual business levels, and highlight the deep interdependencies of the “real economy” and the “financial economy”.

Characteristics of black swan events

The Black Swan, written in 2007 by Lebanese-American scholar and statistician, and former options trader, Nassim Nicholas Taleb, described “black swan” events as having three key characteristics:

• they are unexpected and rare, thereby lying outside the realm of regular expectations
• their impacts are wide ranging or extreme
• they can only be fully understood after the fact

Black swan events can come in many forms, many of which have lately come within the purview of the highly influential World Economic Forum’s annual Global Risks Reports, and include events such as terrorist attacks, cyber attacks and pandemics. 

Perhaps the most noteworthy feature of black swan events, and that which now influences the policy thinking of such groups as the Bank of International Settlements (BIS), is their probabilistic characteristics. Unlike normal distributions, these events typically are non-linear in nature, heavily skewed with fat-tailed probability distributions.

This makes redundant, backward-looking approaches to understanding risk given their occurrence not being reflected in past data coupled with the possibility of extreme values.
Both transition and physical climate-related risks demonstrate features of black swan events, hence the BIS’s adaptation of the phrase “green swan”.

The BIS draws out three additional complexities which make even more profound the challenges in guiding their advice to central banks:

First, the scientific consensus from the Intergovernmental Panel on Climate Change (2018) points to a growing gap between current temperature trends and emissions reductions targets, leading to somewhere between 3ºC and 4ºC of warming.

This is illustrative of ongoing uncertainty about the strength and effectiveness of public policy and the timing of emissions reduction trajectories.

Secondly, climate catastrophes are potentially more serious than systemic financial crises, as they pose an existential threat to economies and humanity, with potential for very deep cuts in global GDP.

Thirdly, complexity is of a much higher order with potential for complex chain reactions and cascading effects across both physical and transition dimensions generating further unpredictability in environmental, geopolitical, social and economic dynamics.

If it were not already clear, central banks, regulators and supervisors have a remit in relation to climate change, while governments remain primarily responsible for ensuring the success of the Paris Agreement.

These mandates are centred on responsibility for price stability, financial stability and the safety and soundness of financial institutions.

Accounting for ‘green swan’ events going forward

What does the “green swan” tell us about the tools and approaches being developed for dealing with uncertainty where traditional backward-looking risk assessment models, which merely extrapolate historical trends, prevent a full appreciation of the future systemic risk posed by climate change?

The BIS’s position is that the avoidance of exceeding climate tipping points requires immediate and ambitious action towards structural transformation of our economies, accompanied by technological innovation that can be rapidly scaled-up.

Over and above strengthening the role of the financial system to manage risk, this will involve the mobilisation of capital for green and low-carbon investments.

Among the many threats the BIS is seeking to guard against is a green swan event, or combination of events, rendering central banks having to intervene as “climate rescuers of last resort”; compelled to buy large sets of devalued or stranded assets so as to save the financial system from collapse.

Understandably, the BIS is a strong advocate of forward-looking approaches grounded in scenario-based analysis, as promoted by other agencies such as the Financial Stability Board’s Taskforce on Climate-Related Financial Disclosures, and that these be embedded in the financial industry’s risk framework agendas and processes of climate-related prudential regulation. 

Instruments presently in a state of advanced development, and currently under consideration – at least at policy level in jurisdictions including Australia and Malaysia – include the EU Technical Expert Group on Sustainable Finance’s Taxonomy (March 2020). 

Expressed in simple terms, the Taxonomy’s structure provides a methodology of technical screening against six predominantly climate change-related objectives, operating alongside a “do no significant harm” environmental principle, applied across a defined structure of sectors emphasising characteristics of economic connectivity and interdependency.

The BIS, nevertheless, points to scenario-based analysis being only a partial solution in fully safeguarding the climate-related vulnerabilities of the global financial system. 

Significantly, it states “that no single model or scenario can provide a full picture of potential macroeconomic, sectoral and firm-level impacts caused by climate change”, thus urging “system-wide” action. 

In terms of firm-level impacts operating within system-wide transformation, a potential insight for accountants from “green swan” could be how we approach certain technical assessments and judgements - particularly around impairment of assets. 

The relevant financial accounting standard, IFRS/AASB 136, details the basis for estimating cash flows as part of determining value in use, and states at paragraph 34 that “management assesses the reasonableness of the assumptions on which its current cash flow predictions are based by examining the causes of differences between past cash flow projections and actual cash flows”. 

Maybe the idea of black swan events points to inherent weakness in such reliance on the “past telling us things about the future”, compelling deeper and more critical analysis of the external evidence.