How the carbon bubble could create another global financial crisis

Financial markets are too short-termist to assess the overvaluation of energy assets.

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Investors’ failure to accurately assess economic risks before the 2008 global financial crisis led to the emergence of a giant debt bubble. Today, their failure to account for climate risk has led to the emergence of a huge carbon bubble: the overvaluation of certain assets resulting from this failure. One recent report estimated that the carbon bubble could be as large as $100trn by the end of this century.  

Most firms face climate risks of one kind or another — whether physical risks, like damage to assets resulting from extreme weather events, or transition risks, like fossil fuel assets falling in value as the world moves away from dirty energy. Some firms voluntarily disclose these risks, and their plans to address them, but reporting on carbon risk is not currently mandatory, and not all firms are transparent about their exposure. 

This week the government unveiled its green finance strategy, which sets out plans to work with the UK’s finance sector to decarbonise the economy by 2050. After Labour announced plans to review the reporting of climate risk by publicly-listed companies last week, the government has stated that it will explore ways to “set expectations” on climate reporting for firms. 

If financial markets are too short-termist to ask the right questions about climate risk, then governments should have to force firms and asset managers to disclose this information themselves. The aim of mandatory disclosure would be to make it harder for those most exposed to the carbon bubble to access finance — the more climate risk a firm is exposed to, the harder it will be for them to borrow money from banks and on financial markets.

The problem with this strategy, of course, is that it relies on investors taking seriously the risks that firms and asset managers report. If, as seems likely, climate change will affect almost all areas of economic activity before the century is over, then investors will not be able to insulate themselves from climate risk by divesting from particular assets. 

A second problem is that no one knows when the carbon bubble is going to burst. The planet has already started to experience some of the effects of climate change, and yet most investors still see the problem as a long-term issue unlikely to affect them within their lifetimes. 

Parallels with the financial crisis are easy to draw — many people within the system saw the crisis coming long before it happened. But most found it more profitable to carry on playing the game until the music stopped, rather than sitting out because they knew the game was going to end. 

In this sense, the government’s strategy for climate risk reporting doesn’t go far enough. Mandatory reporting should be introduced as soon as conceivably possible. But investors must also be forced to act on these reports. Why not, for example, expand asset managers’ fiduciary responsibilities to include the responsibility to reduce their exposure to climate risks? Or expand the responsibilities of the central bank to include monitoring of commercial banks’ exposure to climate risk? 

Common Wealth, a new economic think-tank on the British left, argues that a radical new approach to green finance should be a key pillar of the Green New Deal currently being considered by political parties across the spectrum. A report published this week sets out plans to reform private financial institutions to gear them toward low-carbon investment and to give the Bank of England the power to use credit guidance to direct investment away from “brown” carbon-intensive assets and towards “green” sustainable ones, as well as imposing binding fiduciary duties on investors to mitigate climate risk. 

Mat Lawrence, Common Wealth’s director, argues that we can’t tackle the climate emergency using markets alone —instead, financial markets must be “actively reshaped by the public sector, with a more ambitious programme of public investment anchoring a Green New Deal”. Lawrence cautiously welcomed the government’s report as a first step, but added that the real question was whether the government will move from disclosure to “mandatory requirements that force divestment with the speed that is required. Tinkering won’t be enough in the face of systemic crisis”. 

Ultimately, the government is unlikely to take the radical steps needed to address the climate emergency. The comments of John Glen, the City minister, about the release of the report were revealing: the green finance strategy would “not only protect our environment, but also help establish London as the pre-eminent international centre for green finance”. 

As long as the fight against climate change is couched in terms of the national economic interest — conflated with the interests of the City — we’ll never achieve our decarbonisation objectives.

Grace Blakeley is the New Statesman’s economics commentator and a research fellow at IPPR.