Patrick Bolton, the Barbara and David Zalaznick Professor in Columbia University and who was President American Finance Association in 2015, presented at Luohan Academy's Frontier Dialogue. Eric Maskin, the Adams University Professor and Professor of Economics and Mathematics at Harvard, discussed Patrick's presentation. The following text features transcripted excerpts. It has been lightly edited for clarity and length.
Speaker presentation by Patrick Bolton
The next topic is climate change, risk and financial stability. Patrick Bolton from Columbia University and Imperial College will be presenting. Patrick is also a member of the academic committee of Luohan Academy. Among his numerous achievements, Patrick is a former American Finance Association President. Patrick, please take it away.
Thank you, Neng. I have to switch to speaking mode from listening mode. This was a very interesting set of presentations so far. Some of these presentations actually touch on points that I'm going to make. If that's the case, I will just step over them quickly. Financial stability and climate change, how do we get here? That's what I want to touch on. Also, what are the implications? In the specific angle I will start with is how central banks got into this picture, because that's not completely obvious. That's what Harrison referred to earlier. Central banks are now very actively researching this topic and introducing policies. We want to understand how we get here. My understanding how this all make sense is that in a way, we have to go back to the Great Financial Crisis or the Global Financial Crisis, and see how a central bank mandate has changed after the crisis.
Eventually, the change is that there is a new focus on the financial stability component of central banks that had been forgotten but now became essential again. In addition to that, the idea of macro potential policies is a big innovation which implied that the focus for financial stability should be on the stability of the whole system, not just the stability of individual institutions. That was a major change. Along with that, a policy has become now mainstream, which are the periodic stress tests of the stability of the system under particular adverse scenarios.
Now, climate change gives rise to new systemic risk. That's the angle that makes this relevant for central banks. Here, the history is interesting. The first meeting of central banks to discuss this was in April 2018, involving supervisors in about 30 countries. That's when the Network for Greening the Financial System (NGFS) was launched, which Harrison referred to earlier.
A few months later, the first report came out by the NGFS is how they justified the central bank actions, supervisory actions, and climate change risk, which is a source of financial risk. It is, therefore, within the mandates of central banks and supervisors to ensure that the financial system is resilient to these risks. I should say here that the mandate question is a really important one. It has different answers depending on the country, because of the different institutional constraints. If you want to really go into this in detail, it is a fascinating a panel that you can follow on Youtube the closing panel with the central bankers of the green swan conference that was held in June, which I highly recommend.
However, the world today is the US Federal Reserve joined in the NGFS in December. Now we have 95 members and 15 observers. This is a very big chunk of the central banking, supervisory bank, and supervisory community. If it's part of the mandate of central banks, you might ask how essential banks should take account of climate change risk. Here I just want to give you a few bullet points that are developed a greater length in a paper I wrote with my courses that are listed here, titled the Green Swan, Central Banking and Financial Stability in the Climate Change Age.
Basically, some of the points that were raised in the earlier presentations, I will echo here. It's the first thing that's pretty obvious to realize is that you can't do traditional and backward-looking risk assessment models, because we are in an unstable and changing world, where climate change is becoming more and more material. It wasn't in the recent past.
Any other major point to take into account is that there is a climate change. It's already happening, and it's certain to happen. This is a very predictable trend. If anything, we are underestimated the speed at which it's happening. The third point to bear in mind here is about some of the economic writings on climate change that around integrated assessment models. While they are helpful for the earlier discussion we heard, they remain sketchy and lack granularity. I think that's important to bear in mind. In particular, they don't always integrate financial markets, financial constraints, and transition risk. Chain reactions are social, political, geopolitical risk. There's a lot of things that still need to be considered as being integrated into the analysis. What can central banks do, given that the two seems for now at least severely constrained and a highly limited? I think here what's interesting is how central banks are starting to take that on board.
The key words here are scenario-based forward-looking analysis. In some ways, you could think of the model that we just heard that Harrison presented as such an analysis, a scenario-based forward-looking analysis. I think that it's important way of somewhat different interpretation that once you accept, it's a scenario. You're less constrained in some ways, and you're looking for slightly different things in your quantitative analysis. That's the first big point to bear in mind, where we are headed. Now, the second point is that we are facing huge uncertainty. Here I just want to add that the uncertainty, in particular also lies with the effectiveness and timely deployment of new technologies. We need to acknowledge that uncertainty. Another thing I want to put on the table here is that we need to think in terms of system transition. This is maybe something we can come back later in our discussion.
What are central banks currently doing? The scenario-based analysis has so far been implemented or is currently being implemented in the form of climate stress test around net-zero targets. The lead has been taken by the Bank of England by annual exploratory scenario, which has started this year. It's interesting to see what the Bank of England is trying to do, and this is really just the first step. It asks major UK banks and insurers to estimate the size of climate change risks under three aggregate scenarios that it puts to them on three different scenarios in terms of the speed at which the UK economy will reach net-zero. Then these institutions have to report back on how they will adjust their business models under each scenario.
Eventually, you can think of this exercise as a form of indicative transition planning with the central bank or some other planning authority. If you want, you can give the pathway information, in aggregate to the different agents in the economy. It's up to them to adapt or coordinate around that pathway. Now, the challenge is enormous. Here just want to show you this picture. So roughly, while you read this picture, let me say roughly what is involved here. I mean this is really quite staggering. Roughly, we need to decarbonize the global economy from now on at a rate of 6 to 7% per year.
Now, we've achieved that in 2020, thanks to COVID restrictions, lockdown and lower economic activity. With the return to full employment and full activity in 2021, carbon emissions are rising again. We're not going to achieve it in 2021, which means that we have to decarbonize it even higher rate going forward on a yearly basis. This is enormous challenge. What central banks are getting involved is trying to take control of this issue and try and manage this carbon transition. In my last slide here, I want to maybe come back to the digital pathway to net zero. In my view, they are the key four main steps to get to net zero if we ever get there. And the first point has to do with measuring and reporting carbon emissions.
First of all, what we need to measure is direct and indirect emissions. Then we need to measure them at the entity level. That's done currently pretty well for publicly traded companies, but for the privately held companies and the non-listed companies, it is a dark universe. We know very little about that. Even just on the entity level, we have a lot of data still that we need to obtain. Now, what's interesting is that by using a digital technology, big data, AI, multiplication of sensors, satellite monitoring, we can achieve much, faster, much quicker information on where carbon emissions are, what transactions, what companies and so on. This is what is referred to as the age of radical transparency.
Let me turn to the second step. Once you have the data, you want to define forward-looking scenarios and decarbonization pathways. That's pretty clear. Then it comes to third step and we touched on that very briefly earlier. Part of the implementation of the company path is has to go through a global efficient market for carbon offsets. Here again, digital technology has an important role to play. Let me just leave it at that in the interest of time and finish with the 4th step, an important step, which is investment in green tech. Here, my view is that we need to do two things. One should be obvious in terms of this conceptually, but maybe not politically, which is to stop fossil fuel subsidies. The other one, which is easy to understand how we solved COVID in front of us. That's the operation warp speed effort. That's what we need for climate, and at least for acceleration of climate technologies. Whether it's more efficient, renewable energy, or carbon capture and sequestration technology, we need a massive green of operation, a warp speed program to accelerate innovation.
Discussant presentation by Eric Maskin
The discussant is Professor Eric Maskin. Eric is Adams University Professor of economics and Mathematics at Harvard. Eric is a Nobel Laureate and also a member of academic committee of Luohan Academy. Eric, please take it away. Thank you.
Thank you. Thanks to the academy for organizing this important meeting, and thanks to Patrick. It's the most interesting discussion. I'm going to have to offer him an apology, though, because I didn't realize that he was going to be speaking on financial stability. My plan had been to talk more or less on the same issue that Harrison and Lars were talking about climate friendly investment. I think I will come back to that issue. The ESG movements in an investment has a been attracting a lot of interest and momentum in recent years. Here the E stands for environment, the S stands for society, the G stands for governance. I'm going to focus on the E part, the environment, and more specifically on climate change.
The idea is that investors will put their money only in firms that have good records on climate change. As a result, firms will try to acquire and maintain good records on climate change. Now, interestingly, this idea goes against a few prevailed for much of the 20th century. The idea that firms and investors have no obligation to take on social concerns in their businesses, such as climate change. In fact, famous proponent of this idea, Milton Friedman went so far as to say that the sole responsibility of a firm is to make money for shareholders and doing anything else, such as reducing carbon emissions, is a violation of the air conditioning. For treatments, reasoning was that shareholders are on the firm and firms have responsibility to act in shareholders' best interest. Shareholders invest money in the firm to get a financial return.
The firm should act accordingly. Each shareholder is free to put her money toward any social goals she wants, or learning for example. She can put the money into mitigating climate change, but the firm should not do this for that. There is no need. These arguments, sound possible and have certainly been very influential. But there, it's a number of importance. It may turn out that many shareholders care about what the firm does socially. This is a point that was made interestingly, and in a recent paper by Oliver Hart. It may be that shareholders are unhappy, if their firm is emitting a lot of carbon dioxide. Additional money that they would earn if the firm reduce the emission, refrain from reducing emissions may not be enough to compensate them for the unhappiness.
This is the underlying reason why the ESG investment movements has been such a big topic. These days shareholders themselves want firms to behave in a climate-friendly way. I can only go so far and solving the climate change problem. This is what Harrison and Lars were discussing. This is because it requires investors to be, to some extent, self-sacrifice that they must be willing to give up money, perhaps quite a bit of money for the public good.
We all know that generosity is generous to some extent, if we have to rely on generosity to provide public good. We're likely to come up with a much more effective way of solving the incentives for climate change, which is to introduce a carbon tax or a carbon trade system. You have a carbon tax that firms are charged for their carbon emissions, according to the damage they do. We no longer have to rely on altruism or generosity to solve the problem. You might ask why we should be interested in the ESG movements. Why don't we just impose a carbon tax and be done with it? Everything, that answers the question, is that although carbon taxes could be used, they have not yet actually been used, at least not to the extent needed to come close to solving the problem. In the meantime, we have to make a perfect alternative are such as ESG.
Another possible answer to why we care about ESG is that even if we were imposing a carbon tax, governments are always reluctant to raise taxes because the public to pay them. To the extent that there is a robust ESG movement, carbon taxes can be correspondingly lower. But I think the most important movement is that ultimately, it may make carbon taxes politically possible. Although the political process is imperfect, I'm thinking that the United States, in particular, is in this respect. To the extent that the ESG movement continues to grow, it will be a proof to government. Again, I'm thinking of the American government as the public and business solving the climate change problem. This will not so much influence public opinion, but rather influence government itself and more green power to the ESG movement.
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