What are Green and Black Swan Risks? - COVID-19

With research results showing the devastating impact of climate change on the economies across the globe, it has received a renewed focus from central banks and international institutions like the BIS recently with an objective to build a system that ensures safeguarding the financial stability objective. This led to the institutionalization of Network for Greening the Financial System (NGFS) by the central banks and supervisors. A book recently published in January 2020, titled “The Green Swan – central banking and Financial Stability in the age of climate change”, provides a descriptive account on new ways to address the emerging risks to central banks’ financial stability objective. Given the uncertainty associated with climate change risks, the traditional models with prior information-based approaches fail to account for the social, physical, and economic phenomenon to be monitored or assessed. These risks/events, holding the potential to disrupt the financial system severely to an extent that they could be the cause of the next systemic financial crisis are termed as “green swan” (BIS, 2020). The term green swan has its origins from the now-famous concept of “black swan” developed by Nassim Nicholas Taleb (2007). The Black swan events are characterized by the following features:

a) They tend to be unexpected and rare so lie outside the regular realm of expectations (like the current COVID-19 pandemic)

b) Wide-ranging and extreme impacts

c) Can only be explained after the impact

A Black Swan event/risk can take many forms ranging from an act of terror to natural calamity or technological disruption. In terms of distribution, they are skewed and exponential in growth. As a consequence existing prior information based probability models or Value at Risk (VAR) models fail to explain or predict them.

Green Swans also termed as “climate Black Swans” share many attributes of black swan risks especially the fat-tailed distribution, deep uncertainty, non-linearity, and lack of predictability based on historical data ( Weitzman (2009,2011)).

Nevertheless, there are three key features which make Green Swans distinct from the Black Swans, i.e.:

a) “High degree of certainty associated with climate change risks in a way that some combination of physical and transition risks will materialize in the future” (pp.4 NGFS, 2019) i.e. a certainty about the need to act ambitiously despite having uncertainty about timing and nature of impacts from a green swan event.

DG treasury et al (2017) lists five key financial risks resulting from physical and transition risks:

1. Credit Risk: deteriorating the borrower’s ability to repay the debts, leading to a higher probability of default (PD) and higher loan given default (LGD). In addition to this, the depreciation of assets being used as collateral can increase credit risks.

2. Market Risks: In an abrupt transitional scenario where significant stranded assets, changing investors’ perception can trigger fire sales leading to the financial crisis. This concept is captured in climate-value-at risk (VaR) ( see, Chapter 3, Bolton et al. (2020)).

3. Liquidity Risk: there is a lack of empirical literature available to explain this but it could potentially affect both banking and NBFCs (Non-Banking Financial Institutions). e.g. the balance sheets of the banks can turn poor when hit by credit and market risks due to difficulty in refinancing their own needs in short term and potentially leading to issues in the lending market.

4. Operational Risks: They appear to be less significant though for the institutions which get impacted by physical risks can see the value chains getting impacted.

5. Insurance Risk: here, higher than expected claims can trigger due to physical risks, and potential underpricing of new insurance products that cover green technologies could result from transition risks (Cleary et al (2019)).

b) Devastation stemming from climate risks is far more serious than most systemic financial crises, humanity’s’ existence can come under question (see Ripple et al. (2019)).

c) The complexity related to climate change is far higher as compared to Black Swan events, the chain of reactions generated by green swan events along with cascading effects on physical and transition risks can lead to random environmental, social, geopolitical, and economic outcomes.

Is COVID- 19 pandemic a Green Swan or Black Swan?

Based on the criteria summarizing (See Table 1) the similarities and differences of Green Swans and Black Swans by Luiz Awazu Pereira da Silva (2020), in terms of the impact it has turned out to be a global externality originating from China with a high likelihood of occurrence with multiple non-linear forces interacting together, causing severe shocks in demand and supply.

Further, it has posed a threat to human existence, risking the life of possibly every human being. Also, the linkage between pandemics with climate change in a self-reinforcing framework is summarized in the following excerpt taken from De Silva (2020):

The Road Ahead

With the world going under unprecedented lockdown and economies planning to get back on track with growth, the gains accrued in terms of falling concentration of Carbon dioxide, Nitrogen dioxide, and other pollutants can vanish in no time if appropriate measures are not devised going ahead. The pandemic has exposed various fault-lines in the social infrastructure along with bottlenecks in public healthcare systems, lack of diversified supply chains, etc. The COVID- 19 crisis calls for improving the surveillance of health conditions, locally as well as globally, and the need for engineering a green recovery. Further, the crisis may result in shifting focus towards the acceptance of green policies i.e. a consequence of behavioral contagion theory ( see Linden,2017) which states that a belief, if backed by a significant amount of evidence can lead to behavioral changes. COVID- 19 could be the tipping point of what encourages the societies to fully internalize and understand the complexity of potential risks and dangers across the globe.

References

Cleary, Patrick, William Harding, Jeremy McDaniels, Jean-Philippe Svoronos, and Jeffery Yong. 2019. “FSI Insights on Policy Implementation Turning up the Heat – Climate Risk Assessment in the Insurance Sector.”

DG Treasury, Banque de France, and ACPR. 2017. “Assessing Climate Change- Related Risks in the Banking Sector.” Directorate General of the Treasury.

Luiz Awazu Pereira da Silva1 Based on remarks at the OECD Chief Economist Talk Series, Paris, 23 April 2020 and a Research Webinar at the BIS, 13 May 2020

Luiz Awazu Pereira da Silva , Green Swan 2 – Climate change and Covid-19: reflections on efficiency versus resilience Based on remarks at the OECD Chief Economist Talk Series, Paris, 23 April 2020 and a Research Webinar at the BIS, 13 May 2020.

Patrick BOLTON - Morgan DESPRES – Luiz Awazu PEREIRA DA SILVA Frédéric SAMAMA - Romain SVARTZMAN , The green swan Central banking and financial stability in the age of climate change, BIS 2020

Pereira da Silva, Luiz A. 2017. “Green Finance: Can It Help Combat Climate Change?” Remarks at the conference organized by the BIS, OMFIF, the Deutsche Bundesbank, and the World Bank Group, Frankfurt, 13 July.

Ripple, William J, Christopher Wolf, Thomas M Newsome, Phoebe Barnard, and William R Moomaw. 2019. “World Scientists’ Warning of a Climate Emergency.” Bio-Science.

Taleb, Nassim N. 2007. The Black Swan. New York: Penguin Random House.

Van der Linden, “Determinants and measurement of climate change risk perception, worry, and concern” in M Nisbet, M Schafer, E Markowitz, S Ho, S O'Neill and J Thaker (eds), The Oxford Encyclopedia of Climate Change Communication, Oxford University Press, 2017.

Weitzman, Martin L. 2009. “On Modeling and Interpreting the Economics of Catastrophic Climate Change.” Review of Economics and Statistics 91 (1): 1–19.

Weitzman, Martin L. 2011. “Fat-Tailed Uncertainty in the Economics of Catastrophic Climate Change.” Review of Environmental Economics and Policy 5 (2): 275–92.