A Shift in Temperature: The Financial Challenge of a Zero-Carbon Economy

Tim Jackson and Andrew Jackson

The most fundamental challenge to the finance sector that we face is the need to support the transition to a carbon neutral economy, argued Mark Carney, Governor of the Bank of England, in his annual speech to the Lord Mayor’s banquet this year. Indeed, he said, it is existential.

This is a sentiment with which we are very much in accord: in fact, it is precisely the focus for our new research project under the Sustainable Growth Hub of Rebuilding Macroeconomics, which will explore the environmental, macroeconomic and financial risks (and opportunities) associated with the low-carbon transition.

Carney has been a long-time advocate of the need to take seriously the ‘transition risks’ associated with climate change, pointing out that by the time they become fully apparent, it may already be too late to mitigate them. But his Mansion House speech goes further than anything he has said before, committing the Bank to carrying out a robust ‘stress test’ of the resilience of the UK economy against different ‘climate pathways’, to be completed before the end of 2021. It will be ‘the first of its kind to integrate climate scenarios with macroeconomic and financial models’.

Again, this ambition is laudable and reflects the concerns of Rebuilding Macroeconomics. The network was established precisely to overcome methodological issues in conventional macroeconomics: an over-reliance on steady state models, the potential for discontinuous change and a neglect for financial sector consequences. The ‘climate emergency’ is not an issue that can be overlooked because it does not fit conveniently into our models.

Carney’s speech clearly signals a shift in the temperature of debates around climate finance. It is absolutely aligned with the spirit of our times. Climate scientists now agree that averting climate breakdown requires a whole-scale transition of the economy away from fossil-fuels. Challenged by the school strikes and activism on our streets, the UK Parliament has formally declared a ‘climate emergency’. Government has committed itself to adopting a ‘net zero’ target for greenhouse gas emissions by 2050.

Given the historical responsibility for climate change, and the need for economic development in the poorest countries in the world, there is a very strong argument that developed countries should be adopting earlier targets and several developed economies have already done so, some as early as 2035.Extinction Rebellion is arguing that the UK should reduce carbon emissions to zero by 2025 – and in the face of everyone exclaiming that this is impossible, is calmly recruiting academics, NGOs and policy-makers to figure out how it can be done.

By any account the transition is a formidable challenge. It demands the replacement of entire technologies, supply chains and infrastructures within timescales considerably shorter than the average asset life of the existing investments. Replacement will require directed (or incentivised) investment at a scale usually seen during periods of war or rapid urbanisation, rather than at a scale typical of mature, post-industrial economies. It will also entail widespread changes in the behaviours of households, consumers, producers, investors, shareholders and savers that go well beyond any historically accepted ‘normal’.

These three features of the transition – rapid structural change, massive investment shifts and ‘post-normal’ behaviours – are exactly where Carney’s ‘transition risks’ are situated. Take the risk associated with ‘stranded assets’ as an example. If net-zero targets are to be met, almost two thirds of the proven fossil fuels reserves will have to be left in the ground. One study found that up to $2 trillion of capital expenditures are at risk of stranding in the oil, gas and coal sectors alone.

The potential disruption to financial markets is enormous, in part because of the high market value of those sectors most at risk of asset stranding. But the risks are not confined to firms in the fossil fuel sectors. Handled badly, jobs will be lost, financial assets will decrease in value, debts will suffer default and governments will lose an important source of revenue. The reduction in asset prices will have a negative effect on the consumption spending of asset owners, with potential knock on effects for aggregate demand. Countries in which fossil fuel firms raise a significant amount of capital – such as the UK – are likely to be particularly exposed.

All of this underlines Carney’s evident concern. But his aim of carrying out a robust stress test of the UK economy remains a substantial undertaking. In fact, it poses exactly the sort of challenges to conventional macroeconomics that Rebuilding Macroeconomics was established to address. The over-reliance on equilibrium assumptions, the predominance of rational ‘representative agents’ and the relative neglect of the dynamics of the financial system: all of these are unhelpful in attempts to understand transition risk.

Our approach in this new project will bring together several distinct approaches at the forefront of economic thinking – including Agent Based Modelling (ABM) and Stock-Flow Consistent (SFC) modelling. The Modelling Transition Risk (TRansit) project will develop a macroeconomic framework capable of mapping the complex, dynamic, nonlinear channels through which transition risk impacts on the economy. We intend to make the resulting model fully available to the wider research community to address the many different questions relevant to the zero carbon transition.

We very much hope this will overcome some of the blindness in mainstream macroeconomics to this most pressing global macroeconomic question. TRansit is not just an academic exercise in creating a more heterodox macroeconomics: it is a vital component in the kind of inquiry that Mark Carney has just set in motion for the UK.

Prof Tim Jackson is Director of the ESRC Centre for the Understanding of Sustainable Prosperity (CUSP) at the University of Surrey. Dr Andrew Jackson is a CUSP research fellow with a background in economics and climate finance.