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On Friday, December 10, Markus Brunnermeier gave a lecture on “Finance, Money and Climate Change.”  Brunnermeier is the Director of the Bendheim Center for Finance.

Watch the full presentation below and download the slides. You can also watch all Markus’ Academy webinars on the Princeton BCF YouTube channel.

Executive Summary

  • [0:00] The greening of general policies. New special policy instruments or making existing policy instruments multi-purpose. To evaluate whether the “greening” of existing policies can occur effectively, and whether it interferes with the original policy objectives. However, the greening could reduce accountability, and weaken independence.
  • [5:44] Tragedy of horizons. Climate change has a horizon of decades, financial stability policies have 8-10 year horizons, and monetary policy has very cyclical 2 year horizons.  
  • [8:15] Green finance focuses on taxing the risk associated with pollution: climate catastrophes are one cause of risk, but so are uncertainties associated with both current and future climate policies. They can lead to “stranded assets”. We have to incorporate the risk in stress tests, assessment processes, and portfolios. Climate dominance can become a self-fulfilling prophecy (multiple equilibria): with limited climate risk provisioning leading to strong political resistance, meaning there will be limited stranded assets; the same would hold with strict provisioning leading to limited resistance and more stranded assets. 
  • [13:40] Risk premium as an inefficient “Pigouvian tax”: Creating climate policy uncertainty creates risk and an extra risk premium. Like a Pigouvian tax it can steer the economy towards green investments, but with one big difference: in a Pigouvian tax, the government gets tax revenue, but with this policy uncertainty tax becomes socially wasted in risk premia.
  • [16:26] Time inconsistency and risk premium. A clear policy path will remove planning uncertainty, stimulate investment, and reduce wasteful risk premium. An ex-ante one would like to commit to a clear policy path, either in the form of a pollution tax (to remove uncertainty about CO2 price) or in the form of pollution permits, to reduce uncertainty about emission level.  However, ex-post one needs some flexibility to reoptimize to maintain resilience, especially if one needs to adapt to new information about tipping points.
  • [20:10] Distorting the labor/capital ratios and ESG ratings. Taxing risky capital of polluting firms instead of their output distorts the labor/capital ratio. Additionally, the green tax is heavier on risky firms than steady polluters. Greenwashing is a big problem. ESG ratings from one source are not highly correlated with emissions or with other ESG ratings.
  • [24:53] Green Monetary Policy. Central bank policy has traditionally followed the principle of market neutrality, but two questions must be raised: economically should central banks ignore market failures, and politically, should they ignore the overall political goals? Green policy will impact r* and hence monetary policy. In Europe, investment in green technologies leads to a higher r* because of the investment demand, but r* decreases due to lower consumption growth or increased risk. 
  • [30:00] There are several monetary policy instruments that allow this to happen. Modulating the haircuts (the assets that need to be paid as collateral to the central bank). Central banks can purchase assets in a manner that focuses on green investments, or in a more radical move, sell current assets and buy more green assets moving forward. 
  • [31:31] Green monetary policy can undermine central bank independence as they are drawn in the political roam. The US Fed has a triple mandate. The ECB has price stability as a lexicographic mandate, which raises the question who picks the secondary mandate.