RBA Deputy Governor Guy Debelle, spoke at a public forum hosted by the Centre for Policy Development. Here are some edited highlights.
I will talk about how climate change affects the objectives of monetary policy and some of the challenges that arise in thinking about climate change.
Finally, I will also briefly discuss how climate change affects financial stability.
Let me start by highlighting a few of the dimensions that we need to consider:
- We need to think in terms of trend rather than cycles in the weather. Droughts have generally been regarded (at least economically) as cyclical events that recur every so often. In contrast, climate change is a trend change. The impact of a trend is ongoing, whereas a cycle is temporary.
- We need to reassess the frequency of climate events. In addition, we need to reassess our assumptions about the severity and longevity of the climatic events. For example, the insurance industry has recognised that the frequency and severity of tropical cyclones (and hurricanes in the Northern Hemisphere) has changed. This has caused the insurance sector to reprice how they insure (and re-insure) against such events.
- We need to think about how the economy is currently adapting and how it will adapt both to the trend change in climate and the transition required to contain climate change. The time-frame for both the impact of climate change and the adaptation of the economy to it is very pertinent here. The transition path to a less carbon-intensive world is clearly quite different depending on whether it is managed as a gradual process or is abrupt. The trend changes aren’t likely to be smooth. There is likely to be volatility around the trend, with the potential for damaging outcomes from spikes above the trend.
- Both the physical impact of climate change and the transition are likely to have first-order economic effects.
Climate Change, Economic Models and Monetary Policy
The economics profession has examined the effects of climate change at least since Nobel Prize winner William Nordhaus in 1977. Since then, it has become an area of considerably more active research in the profession.[4] There has been a large body of research around the appropriate design of policies to address climate change (such as the design of carbon pricing mechanisms), but not that much in terms of what it might imply for macroeconomic policies, with one notable exception being the work of Warwick McKibbin and co-authors.[5]
How does climate affect monetary policy? Monetary policy’s objectives in Australia are full employment/output and inflation. Hence the effect of climate on these variables is an appropriate way to consider the effect of climate change on the economy and the implications for monetary policy. The economy is changing all the time in response to a large number of forces. Monetary policy is always having to analyse and assess these forces and their impact on the economy. But few of these forces have the scale, persistence and systemic risk of climate change.
A longstanding way of thinking about monetary policy and economic management is in terms of demand and supply shocks.[6] A positive demand shock increases output and increases prices. The monetary policy response to a positive demand shock is straightforward: tighten policy. Climate events have been good examples of supply shocks. Indeed, droughts are often the textbook example used to illustrate a supply shock. A negative supply shock reduces output but increases prices. That is a more complicated monetary policy challenge because the two parts of the RBA’s dual mandate, output and inflation, are moving in opposite directions. Historically, the monetary policy response has been to look through the impact on prices, on the presumption that the impact is temporary. The banana price episode in 2011 after Cyclone Yasi is a good example of this. The spike in banana prices and inflation was temporary, although quite substantial. It boosted inflation by 0.7 percentage points. The Reserve Bank looked through the effect of the banana price rise on inflation. After the banana crop returned to normal, prices settled down and inflation returned to its previous rate.
The response to such a shock is relatively straightforward if the climate events are temporary and discrete: droughts are assumed to end; the destruction of the banana crop or the closure of the iron ore port because of a cyclone is temporary; things return to where they were before the climate event. That said, the output that is lost is generally lost forever. It is not made up again later, but rather output returns to its former level.
The recent IPCC report documents that climate change is a trend rather than cyclical, which makes the assessment much more complicated. What if droughts are more frequent, or cyclones happen more often? The supply shock is no longer temporary but close to permanent. That situation is more challenging to assess and respond to.
Climate Change and Financial Stability
Having talked about the macroeconomic impact of climate change and how that might affect monetary policy, I will briefly discuss climate through the lens of financial stability implications.[10] Financial stability is also a core part of the Reserve Bank’s mandate. Challenges for financial stability may arise from both physical and transition risks of climate change. For example, insurers may face large, unanticipated payouts because of climate change-related property damage and business losses. In some cases businesses and households could lose access to insurance. Companies that generate significant pollution might face reputational damage or legal liability from their activities, and changes to regulation could cause previously valuable assets to become uneconomic. All of these consequences could precipitate sharp adjustments in asset prices, which would have consequences for financial stability.
The reason that I will only cover the implications of climate change for financial stability only briefly today is that it has been very eloquently discussed by Geoff Summerhayes (APRA) and John Price (ASIC) including at this forum over the past two years.[11] I would very much endorse the points that Geoff and John have made. Geoff stresses the need for businesses, including those in the financial sector to implement the recommendations of the Task Force for Climate-related Financial Disclosures (TCFD).[12] I strongly endorse this point. We have seen progress on this front in recent years, but there is more to be done. Financial stability will be better served by an orderly transition rather than an abrupt disorderly one.
One area that Geoff highlighted in a recent speech is that there is a data gap which needs to be addressed:[13] ‘The challenge governments, regulators and financial institutions face in responding to the wide-ranging impacts of climate change is to make sound decisions in the face of uncertainty about how these risks will play out.’ In that regard, Geoff mentions one challenge that I spoke about earlier in the context of monetary policy. Namely, taking the climate modelling and mapping that into our macroeconomic models. For businesses and financial markets, that challenge is understanding the climate modelling and conducting the scenario analysis to determine the potential impact on their business and investments.
