Rens van Tilburg is member and director of the Sustainable Finance Lab at Utrecht University - http://sustainablefinancelab.nl/

• Excessive credit growth and leverage. Excessive credit growth has been identified as a key driver of asset price bubbles and subsequent financial crises, with leverage acting as an amplifying channel;
• Excessive maturity mismatch and market illiquidity. Reliance on short-term and unstable funding may lead to fire sales, market illiquidity and contagion when the financial cycle turns;
• Direct and indirect exposure concentrations. Exposure concentrations make a financial system (or part of it) vulnerable to common shocks, either directly through balance sheet exposures or indirectly through asset fire sales and contagion;
• Misaligned incentives and moral hazard. This includes risks associated with systemically important financial institutions and the role of implicit government guarantees.

We distil four criteria for including asset classes as financial crisis prone and hence relevant for macroprudential supervision.

• The first is the maturity of an asset. An abrupt change in the services of an asset with a long maturity can lead to a major downward adjustment of its price, as future services become less worthwhile;
• The second criterion is the capital intensiveness of an asset. As the market value of an asset drops below its marginal cost price, the production of that asset will be halted leading to a realignment of resources in the real economy;
• The third criterion is the economic share of an asset class. What proportion of the economy is affected?
• The fourth and final criterion is the amount of debt financing of an asset. While equity can absorb financial shocks, failure on debt may propagate a financial shock.

The four criteria are cumulative. So an asset class needs to fulfil all criteria in order to be crisis prone.


Are environmental risks material for macroprudential supervision?

The first question is whether macroprudential policies should also target the ecological risks that are building up outside the financial system itself? Financial shocks may originate from ecological imbalances, triggered by either intensified environmental policies, technological breakthroughs (e.g. cheap renewable energy), and expectation of this in financial markets or due to the economic costs of crossing these ecological boundaries (e.g. climate change disrupting economies). In the case of environmental risks, adjustments may be severe and abrupt, leading to disorderly markets and substantial losses for financial institutions.

But are these factors material for macroprudential supervisors? Macro estimates of current ecological imbalances, as measured by the unpriced externalities, suggest they are. The average annual economic cost of human-induced environmental depletion was estimated at approximately $6.6 trillion in 2008, equivalent to eleven per cent of global GDP (UNEP FI, 2011). If environmentally unsustainable activity continues at this scale, the annual costs for the global economy will reach nearly $28.6 trillion by 2050, equivalent to eighteen per cent of global GDP. Of this, greenhouse gas (GHG) emissions account for a large and growing share of environmental costs, rising from 69 to 73 per cent between 2008 and 2050.

The cost of environmental damage [3] caused by eleven key industry sectors in 2010 was equivalent to forty-one per cent (KPMG, 2012) to over half (UNEP FI, 2011) of their pre-tax profits. Some sectors, such as food producers, would have no profits left if they had to pay the full cost of their negative environmental externalities (KPMG, 2012).

The existence of externalities as market failure is the ratio behind the new macroprudential policies of financial supervisors: to act on systemic risks that individual financial institutions have no incentive to act upon.

Focusing specifically on the case of the carbon bubble we find that the carbon intensive industry is capital intensive and the assets (e.g. power stations or car plants) are long-lived. The bursting of the carbon bubble, or a substantial increase in the carbon price due to a carbon tax, can thus lead to a major downward adjustment of the value of these assets. On the third criterion, we show that the carbon bubble affects a large part of the economy. Finally, we find that exposures to fossil fuel firms are largely debt financed (at 62 per cent). Utilities (including for energy) are also to a large extent debt financed, typically between 50 to 80 per cent. So a large swing in asset prices can lead to substantial losses on debt. We conclude that the carbon risk as to the financial system appears to tick all boxes of the macroprudential policy framework.


Instruments to counter the systemic threat of ecological imbalances

So what instruments can financial supervisors use to reduce the systemic risk of ecological imbalances? Of course, the first best option is for government to price these risks (e.g. carbon taxes, emission rights and caps). The earlier governments adopt climate policies, the better these risks can be contained.

Nevertheless, as these policies currently are not sufficiently implemented, systemic financial imbalances resulting from ecological pressures are allowed to build up and concentrate in certain financial institutions and markets, thus threatening financial stability.

Several financial market imperfections make that individual financial institutions are not willing or able to effectively reduce these risks. As potential systemic risks are left to build up, macroprudential authorities have a role to play.

The question then is how macroprudential policies can address ecological imbalances? We explore how macroprudential tools can be designed to curb specifically the carbon bubble and identify capital instruments (adjusting risk weights), caps, large exposure restrictions and stress tests as the most promising instruments (see Table 1. Illustrating this for the case of carbon emissions).

Table 1:  Instruments for the Carbon Dimension of Macroprudential Policy

Panel A: Cyclical pillar

Panel B: Structural pillar

Conclusion and further research

Our study is a first exploration, one that suggests that environmental stress could be a relevant target for macroprudential supervisors. However, the problem is that currently there is a severe lack of data on the potential financial impact of, for instance, the ‘carbon bubble’, climate change, water and material shortages and other ecological factors.

It is therefore important to develop scenarios for the different sustainability challenges that provide estimates of losses and gains for different financial assets (equity and debt) over different economic sectors and the kind of companies within those sectors.

This further research can clarify which sustainability themes are the most important from a financial stability perspective. This may also help in deciding which of the here described macroprudential instruments are best suited for this challenge. Lastly, in order to stimulate learning and identify potential weaknesses in the supervision of the globally connected financial system, we propose that both the IMF’s FSAP [4] and the FSB’s [5] assessment of macroprudential policies take into account this ecological dimension.

[5] Financial Stability Board.