Joseph Mariathasan: Climate change and central banks

The debate over climate change is certainly heating up – both metaphorically and literally. Record temperatures were reported across the globe last month and the UK’s Met Office stated that the top 10 warmest years on record in the UK have all occurred since 2002.

Even central banks are taking it seriously. Gary Smith, managing director at Barings Investment Institute, argues that under the extreme scenarios we appear to be experiencing, the traditional central banker’s focus on a 2% CPI forecast might become meaningless.

“The 2°C target – the threshold an increase in the average global temperature is believed to yield catastrophic results if crossed – might become a target that overwhelms all others,” he says.

Just how central banks will ultimately incorporate concerns about climate change into their mandates remains to be seen, says Barings’ Smith. Capitalism, according to Bank of England governor Mark Carney, is part of the solution to tackling climate change.

Smith argues this increased focus from central banks on climate change has implications for investors in three areas:

• Macro-prudential risk – payouts triggered by climate catastrophes could destroy current insurance business models, which could in turn result in taxpayers becoming the ultimate backstop for this industry;
• Monetary policy – extreme weather events will have a direct impact on variables that the central bank is charged with targeting, such as the local inflation rate;
• Reserves management – central banks can loosen rules governing their investable universe to be able to diversify more into green assets.

Radical rethinking is required across a whole range of issues, of which energy policy is the most important. There has been a great deal of talk about replacing fossil fuel-based energy sources with alternative energy in the forms of water, wind and solar power. Such energy sources clearly have their place, and as prices reduce and can be set free from government subsidies, their importance rises.

However, to assume that they alone can replace fossil fuels in a modern economy seems fantasy. Wade Allison, emeritus professor of physics at Oxford University, pointed out in a newsletter in 2018 that one kilogramme of water behind a dam that is 100 metres high could provide just 1/3,600 kilowatt hours (kWh) of energy. One kilogramme of coal, on the other hand, provides about 7kWh of energy – 20,000 times more.

As a result, hydroelectric schemes have to be enormous to generate the same amount of energy as a coal-fired equivalent. The environmental and human costs of such schemes are themselves controversial. China’s Three Gorges reservoir on the Yangtze River, which stretches for 600km and is the largest such project in the world, required the relocation of 1.3m people.

Wind power also suffers from a low energy density. At their peak, wind turbines can produce as little as nine megawatts per square kilometre. As Allison points out, to match a one-gigawatt coal-fired plant requires several hundred turbines. The same goes for solar energy, which requires covering vast areas of hillside and meadow.

The economics of the energy industry are heavily influenced by direct and indirect government subsidies – so much so that it can be difficult to extricate fundamental economics of different choices. The situation becomes even more confused when the risks associated with nuclear power have been historically misrepresented.

If central bankers are also now joining in the debate over climate change, there may be more chance that countries like the UK start looking at energy policy with a fresh perspective.