By focusing only on risks to carbon intensive assets, whilst ignoring the possibility that current climate policies may be creating malinvestment in renewable energy technologies, the Bank of England is failing in its statutory duty to identify and address risks to the resilience of the UK financial system.
The Bank of England is under a statutory duty to “identify, monitor, and take action to remove or reduce risks that threaten the resilience of the UK financial system”. Consequently, as an article published as part of the Quarterly Bulletin on the 16 June explains, the Bank is engaged in an ongoing examination both of the physical risks from climate change, and “transition risks” from the shift to a low carbon economy.
While some will think that the Bank overstates the physical risks (hazard x probability) “which can arise from climate-related events, such as droughts, floods and storms”, they have extensive company in taking that position, and one can easily imagine the pressures on the staff responsible not to allow any qualification. That is regrettable, but it is certainly not wrong in itself to consider extreme threats in a risk assessment. Indeed, that is the function of risk assessment.
A more serious failure, in my view, is the narrow characterisation of the “transition risk”. The Bank sees this entirely in terms of risks to carbon related assets, in other words to “sectors involving the production of fossil fuels, such as coal, oil and gas” and also “utilities, heavy industry, and the transportation sector, among others, whose business models rely upon using fossil fuels or are energy intensive” (p. 7). Nowhere in this document is there any evidence that the Bank recognises that the very large investments in renewables, the Bank itself mentions “tens of trillions of dollars”, are themselves far from copper-bottomed.
One need not be dogmatic about this, simply open minded, but in fact the signs are not overwhelmingly positive. Renewable energy required very heavy subsidy to enter the market, still requires it, and will require it for a very long time to come. A much more balanced assessment published this week by J P Morgan, Many Rivers to Cross: Decarbonization breakthroughs and challenges (June 2017) notes that solar power auction prices seem to be converging below $100/MWh, a very high price, that most of the projects making these bids benefit from some sort of government subsidy, and that the International Energy Agency (IEA) is reporting that even as late 2040 half of world solar power will still need subsidy, and that in that year fossil fuels will still be providing the bulk of, for example, electricity in the United States. The renewable energy sector is not mature, and its realistic prospects are modest at best.
Furthermore, there are fundamental physical reasons for thinking that renewables may have no long term role in any future energy system. Renewable energy sources are low density flows. The entropy of these energy sources is high, as compared to the very low entropy of fossil and nuclear fuels. A great deal of low load factor capital equipment is required to collect, concentrate, and deliver these stochastic flows to consumers in the form of timely and controllable energy. This suggests an energy system based on renewables will be one of comparatively low productivity, a fact that would have very important and one would have thought obvious implications for wealth creation. However, in a strikingly one-sided summary the Bank of England writes that:
The allocation of capital and labour to projects not aligned with climate policies and technological changes could be a drag on productivity and economic growth. Conversely, allocating capital and labour to green technologies can be growth-enhancing.
Then again it might, and not at all improbably, be quite the other way around. Failing to allocate resources to projects not aligned with climate policies may destroy wealth, and directing them instead to green technologies could well reduce productivity and suppress growth. Why does the Bank not consider this unwelcome outcome? The study, after all, is a risk assessment, a type of analysis in which the authors are under an obligation, in this case a statutory obligation, to consider all the hazards, no matter how disagreeable.
Judging from this document the Bank of England is failing in its statutory duty to identify and address threats to the financial stability of the United Kingdom. There is, no doubt, a real possibility that the policy driven commitment of capital resources to renewable energy generation is malinvestment that will have to be written off within a decade or two, but the Bank, which now writes as if it were part of the policy delivery mechanism, does not give any consideration to this “transition risk”. Regardless of how probable you think that risk, this omission is clearly a mistake.