Mark Carney: Past crises teach us to put people and planet first
Mark Carney is the UN Special Envoy for Climate Action and Finance to prepare for COP26 in Glasgow in November 2021. He was governor of the Bank of England 2013-2020. He delivered these thoughts to the British Academy Summit on the Future of the Corporation on 24 June 2020.
- Business must prep decisively for climate stress testing
- Systemic risk can’t be wished away
- Risk and environmental destruction are under-priced
- Strategic and social re-set under way at high speed
- Existential risk is now huge commercial opportunity
I want to start with a broader lesson from crises.
Every crisis calls into question aspects of how we value and what we value as a society. That’s because crises normally have some form of mis-valuation at their heart.
The global financial crisis was caused by the under-pricing of risk and the surrendering of supervisory judgement effectively to the wisdom - perceived wisdom - of the market.
The climate crisis is first and foremost caused by the tragedy of the commons. We’re not fully pricing externalities from pollution. We’re effectively ignoring the costs of environmental degradation and species loss.
But also the tragedy of the horizon where we are undervaluing the future and creating a terrible legacy for future generations.
The COVID crisis in part reflects years of undervaluing resilience despite ample and varied warnings of this risk. In fact, the annual advanced preparation costs for this would have been less than one day’s lost economic output this year.
Huge reset under way at high speed
The second lesson moving to lessons from financial or general crises again is that crises lead to changes in strategies. And of course, the question that’s on the table is: strategies for whom or for what benefit?
Companies have stakeholders: employees, shareholders, creditors, customers, suppliers and their communities. But companies are also stakeholders themselves. They have interests and responsibilities for the economic and social and environmental systems in which they operate.
It’s these joint responsibilities that get brought together, and brought to the fore in times of great change. That’s whether it is tectonic shifts brought by new technologies as part of the fourth industrial revolution - shifting geopolitics - which are affecting and shifting us from globalisation to de-globalisation. Or changing social values, including renewed imperatives for social justice and equity.
Into this mix comes the COVID crisis, triggering both a strategic reset - I’d argue for companies - and a social reset for countries. And purpose of all corporations to recognise that they need to align their strategy to those values. Then their actions will be decisive in hoping to achieve those goals.
I am going to spend a moment on the economic drivers of the strategic reset. There is an acceleration of change in the economy, new values of drivers.
This is often observed at these types of meetings: evidence of the acceleration of the digital economy in all its aspects, shift to global supply chain from global supply chains just in time to just in case global supply chains. Consumer attitudes, shifting its entire populations. They have brushes at least with unemployment and feel the anxieties of inadequate access to healthcare. And a wholesale financial restructuring which is yet to begin.
But it’s coming, particularly in large, emitting sectors and in an economy where there is substantial additional debt in the private sector. So for all those reasons, if you had the right strategy coming in to this crisis, you’re likely at a minimum, to have to adjust that strategy to those new realities.
On top of that a social reset. We’ve recognised in recent months that we’re not independent individuals. We need to act as part of an interdependent community. And so the values, dynamism and efficiency joined by those of solidarity, fairness and passion.
Second is recognition about inequalities more greatly exposed. We may all be in the same storm but we’re not all in the same boat. Frances O’Grady [General Secretary of the Trades Union Congress] drew attention to this very well.
Thirdly, resilience, clearly more highly valued. We have to learn from the current predicament. COVID proves that you can’t wish away systemic risk. Certainly that is no more the case than it is with climate, which involves the whole world and for which we can’t self isolate.
So there’s a strategic reset. And that strategic reset needs to be aligned with the social reset. And I would argue that in the UK where the transition to net zero is an agreed imperative - it’s actually legislated, and of course, it’s an imperative of climate physics - now is the time for that strategic reset to be aligned with a transition to net zero.
No hiding place for new realities and threats
The third lesson – is invariably – and now moving to finance - invariably with financial crisis, part of the response is to improve reporting. After the 2009 crash in the United States that gave birth to the SEC [Securities and Exchange Commission]. The first thing the SEC did was to put in place a common reporting standard ultimately known as GAP in order that there was truthful and uniform financial data.
In the aftermath of the global financial crisis we did a series of things in order to expose systemic risks and have consistent reporting. So we had - this is remarkable but true - a 500 trillion dollar derivative market which was unreported, unregulated and stuck in a complex web of bilateral trades.
The first thing we did was actually get the information behind those trades and have them reported. We put in place something called IFRS-9 which has just come into place. It has banks report the expected losses from loans as opposed to the incurred losses. So a truer picture of the health of their balance sheets, and also helping to reduce procyclicality.
We’ve made changes to securitisation, which again, show real risks that the banks have. And also we have the banks develop something called enhanced disclosure which reported how they actually manage their risk.
So, again, clear response in terms of reporting. You can probably predict where I’m going with this in terms of turning to climate, which is to talk about the TCFD.
But let me draw a distinction here and underscore it.
What’s happened with past financial crisis is that after the horse has left the barn, if you will, we’ve then improved - and I’m going to be tortured by my analogy - we try to improve the barn after the fact.
We won’t get an after-the-fact with the climate crisis. We have to improve reporting in advance.
I think James Gorman, who’s the CEO of Morgan Stanley, said it well a few months ago when he was testifying in front of Congress. He was asked whether climate change is really a financial risk. It was a short answer, probably the shortest answer in terms of testimonies. He said: “Well, it’s hard to have a financial system if you don’t have a planet.”
And that’s the point. We can’t do this ex post. We have to do an ex ante.
The good news is that the best of the private sector have taken it into their own hands to develop these standards. The TCFD standards are now backed by 140 trillion dollars of balance sheets of all the large asset managers, major banks, insurance companies, pension funds.
They’re in place. And they’re in a place – though not comprehensively in place - in a way that I think is consistent with the principles behind purposeful businesses. Because it’s not just about static reporting and metrics. It’s guidance on governance and risk management: how climate related risks are actually managed. And it’s also forward looking, looking at scenario analysis and how companies intend to adjust.
Now, these standards have been around for about three years, two reporting cycles. They’ve been refined. There’s huge backing for them.
The issue we’re putting on the table for COP26 is to create pathways to make these mandatory. They need to be comprehensive and consistent, so that these risks can be assessed by all stakeholders.
Stress tests for the unthinkable
Moving to the fourth lesson from crisis that I draw attention to which is to reinforce this point around resilience.
We clearly had a fragile financial system going into the financial crisis and we did a series of things in order to make it stronger - more capital, more liquidity, etc. The other thing we have done which has proven effective - I should say that financial regulators of which I used to be part have done - is to stress test the banks against a wide range of potential scenarios: deflation, inflation, massive depressions, sharp change in trading arrangements etc.
Part of the reason to do that is to protect against the risk that you don’t - you can’t – or you don’t know are coming. This is really building resilience for a reason, for a purpose. It’s there to be used when the unexpected happens.
And what’s happened, of course, is that the unexpected has happened is the COVID pandemic. And the banks are in a position as a consequence of not just building up the capital - but running the stress test against them - they are in a position to be part of the solution as we start to build back better.
So what does this mean for climate?
We all know that there are both physical and transition risks to climate. But the big risks, at least from the financial sector perspective, are principally transition risk. And so the risk is associated with banks not adjusting their strategy - or other financial institutions not adjusting their strategy - to what needs to be done in order to be on a path to net zero.
What we’re worried about is if there’s a sudden sharp adjustment - the so called Minsky moment in the adjustment climate.
After all, if you look at very simple and very generous climate budgeting - so if you don’t use one and a half degrees - which is the core objective of Paris - but if you use under two degrees, more than three quarters of the world’s known coal reserves, half of our gas, global gas reserves again proven and a third of oil reserves are unburnable. So they’re on someone’s balance sheet, and they are not ultimately going to be realised.
Climate stress testing is one of the ways to bring that to the fore.
I would welcome the measures taken by BP [15 June 2020 ] which was to look at both the long run oil forecast but also what a reasonable carbon price could be over the medium term if we’re moving to net zero. And then adjust their balance sheet accordingly with in their case an 11 billion pound write down of some of their old energy assets if I can put it that way. But also, strategically pointing them towards the future.
So that’s why we’re working towards having climate stress testing.
It is to develop this expertise, particularly in the banking sector. And expect it’s not just the Bank of England, but a broad coalition of central banks would be fine.
I’ll draw your attention to one other thing related to this. Actually today It turns out that this group of Central Banks – 60 central banks – are publishing a series of climate scenarios that are open source and can be used by anyone in the financial sector and the real economy. Eight different scenarios. You can take them and adjust. And they’re both the climate variables, but the macro economic consequences.
Purpose must embrace Climate Emergency
My final lesson. It is the importance of embedding and establishing a sense of purpose in business.
I think it does bear repeating. One of the challenges in the run up to the crisis is banking became about banking, as opposed to bank clients. Increasingly about transactions, not relationships. Counterparties not clients. And instruments that had been designed to help clients protect against risk were used to leverage exposures and bets, place bets on financial outcomes. And a series of incentive problems grew up.
We took a series of steps to change that - aligning of compensation to risk and reward in the UK. That stretches out to up to seven years with malice and clawback.
We instituted a series working with the private sector - a series of codes of conduct. But most important, I would argue, was putting in place the senior managers’ regime. It links again seniority and accountability. It creates a responsibility for managers to take reasonable steps to train people to provide proper oversight and align strategy accordingly.
Now, what can we do to embed purpose in terms of client?
From a financial sector perspective – so I’m not speaking directly to clients or to companies here. The core objective for the private finance work of COP26 - which is a subset of a much bigger complex effort - is to make sure that every financial decision, professional financial decision, takes climate into account.
That’s an opportunity for finance as a whole to reassert its purpose. For banks, effectively, what we want to do is bring the SMR principles into the heart of bank management of climate risk. That’s being reinforced by things such as the supervisory expectations of regulators, including those sixty central banks, led by the PRA of the Bank of England. So that’s governance, that’s risk management, use of scenario analysis and appropriate disclosure of that.
And then the big thing, I’d argue, the big thing is on investors.
So the question for investors from asset owners to asset managers is: are you investing your clients money in line with their values? If this country as a whole, whether it’s in polling voting records, legislative records, has an objective to move to net zero by 2050, are you investing your clients money in line with that? And how can you tell them? How can you demonstrate that that is indeed the case?
Do you appeal to conversations you may or may not be having, with businesses? Is it your voting record? Or can you measure how those companies themselves are transitioning? And of course, there’s a chicken and egg issue which we should expose (and we are exposing) and address. Because it’s hard to say whether a company is transitioning if they haven’t published a transition plan. But you have to ask them for a transition plan.
So part of what we’re looking to do is to build on things like the TCFD, but ensure that investors have the tools to assess the credibility of company transition plans, measure them against the art of the possible, see who is a leader or laggard relative to you what’s necessary to achieve net zero. And also to report in a comprehensive fashion their own portfolios in ways that are understandable for their clients.
Now, our suspicions - our view - is that that is not ESG ready. It is not boiled down to one number. There’s lots of merit in the better ESG, but the S and the G tend to dominate the E.
I’m calling that the E here is only environment in the way I’m talking about. But of course, you have the employee element, there’s further blending of issues, which is hard to see. We also don’t think that a binary taxonomy which is just free and everything else brown is consistent with what’s necessary, which is a whole economy transition.
I used the example of BP earlier. There is not a taxonomy that would put BP or any energy company in the green - any large energy company - in the green camp. But a company that’s moving from brown to beige to olive to green is central to the transition. And we need tools in order to do that.
So that is part of what we will be working through.
Once investors have this information in a consistent way, there is a question of how they express their view. Do they express it in the market? Do they have a say on transition analogous to say on pay. some would argue and welcome views on that.
So let me conclude by saying there are many lessons from past crises. We often feel that crises are unique circumstances. This is not unique. But this is very large. And it brings a social reset in my view alongside necessary economic adjustments. We have an opportunity to shift the economy to have a whole economy transition, turning an existential risk into what is, in my view, probably the greatest commercial opportunity of our time, and one that puts people and planet first.