Unsecured fossil fuel investment risks a global financial crisis: letter

Unsecured fossil fuel investment threatens wider economy: letterBig banks are at risk of a failure reminiscent of the 2008 financial crisis due to their continued investments in oil and gas development, which are at odds with global climate commitments, an international group of academics and advocates warns.

The open letter from Brussels-based watchdog group Finance Watch asks national financial regulators like the Federal Reserve to require banks to hold more cash to offset loans to all oil and gas developments — particularly new ones.

New fossil fuel developments are risky because the world already produces more fossil fuels than it can safely burn. At least 60 percent of oil and natural gas, along with 90 percent of coal, must stay in the ground to keep warming within 1.5 Celsius above pre-industrial levels, according to September study in Nature.

That means any new investment in fossil fuels should be treated as a high-risk investment, and every dollar that goes into these projects should be balanced with a dollar in cash reserves, both to mitigate the risk to the climate and their lending portfolios, Benoit Lallemand of Finance Watch told The Hill.

“The risk is so high, you should assume that 100 percent of those assets could be lost,” Lallemand said, following the rules that regulators already require for other high-risk investments, like loans to private equity.

The Hill reached out to the American Bankers’ Association for comment.

Currently banks typically only hold about 8 cents for every dollar loaned out to new or existing fossil fuel developments — leaving them at serious risk if those assets are “stranded,” Lallemand said. 

Stranded assets are capital stuck in investments that no one wants to buy — which can happen suddenly, as on the September 15, 2008, when the sudden collapse of the firm Lehman Brothers triggered a market panic that tipped the global financial into a financial crisis.

“Finance is based on expectations, and if risks materialize beyond anyone’s expectations, you’ll have some level of market panic,” said Phillip Basil, director of banking policy at the advocacy group Better Markets — a signatory to the letter.

Before the Lehman collapse, Basil said, plenty of people knew that the financial system was deeply invested in very risky financial products, like the infamous mortgage-backed securities and credit default swaps. 

But expectations still didn’t line up with what turned out to be reality — with disastrous results, Basil noted. The collapse of Lehman suddenly revealed to traders, bankers and investors that conditions were “significantly worse than anyone thought, and that fundamentally shifted expectations,” which accelerated the market crash. 

That kind of traumatic surprise — a “Lehman moment” — is what Finance Watch and its signatories want regulators to head off. 

There are many potential triggers for such an event, Basil said: a series of acute climate disasters, a rapid uptick in warming or an epiphany that new developments are a sunk cost, because there’s no market for all the fossil fuel reserves in the ground.

But the potential result is the same, if banks don’t have enough money on hand to offset the sudden losses. “All of a sudden people are panicking, and the market is panicking. And then you could have the kind of rapid deterioration in not only asset prices but economic activity that we saw in 2008.” Basil told Equilibrium.

Finance Watch’s Lallemand argued it could even be worse — and not just because taxpayers could ultimately end up holding the bag again. Policymakers will be under pressure to respond to a financial crisis at the same time they are deploying more resources to contain a worsening climate crisis and related disasters, pandemics or water shortages. 

“We are saying to regulators, ‘Don’t add a financial crisis to a climate crisis,’’ Lallemand said, because in an acute climate crisis, “your resources will be stretched to say the least.” 

The proposed regulations are comparatively “common sense,” Lallemand said: a one-to-one capital requirement for new fossil fuel development, and an increase in the reserves for existing fossil fuel development from 8 cents to 12 cents held in reserve to every dollar invested

This is not “a moonshot ask from an NGO,” Lallemand said. “We don’t want to hijack prudential regulation to do a green transition. We just want prudential regulators to use the system consistently,” by treating climate risk as they would other forms of risk.

But while the European Central Bank and Bank of England are in early stages of exploring capital requirements for fossil fuel investments, in the United States the issue remains controversial with Senate Republicans arguing financial regulators have no mandate to wade into such “bitterly partisan issues.”

The prospect of oversight of environmental, social and governance topics like climate change “has inserted the Federal Reserve into the emotionally-charged political arena — a place where the Federal Reserve seldom has ventured, and for good reason,” Sen. Pat Toomey (R-Pa.), the ranking Republican on the U.S. Senate Banking Committee, said in a letter to the San Francisco Federal Reserve. 

But climate advocates argue that the appearance of politicization — a key concern of regulators like Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell — is the inverse of the true problem. 

“The role we need financial regulators to play is to contribute to the depoliticization of this issue,” said Kathleen Brophy, a campaigner at The Sunrise Project, which signed the Finance Watch letter.

Instead of treating climate change as political, “we need them to value and provide credibility to the economic and financial arguments for getting the U.S. off fossil fuel. Their role is not to get hamstrung by politics but to lead in their field,” she said.