John Banks was woken by his phone at 3am on Sunday 26th April 2035. John worked for Garland Brothers. It was the bank’s legal counsel, Peter Thompson, calling. He had dramatic news. Garland Brothers, one of the world’s oldest banks, would tomorrow declare bankruptcy. As he lay there, unable to return to sleep, John tried to reconstruct the events of the last 15 years which had seen climate-related events rip a bankruptcy-sized hole in the bank's loan portfolio.
14 years earlier John had attended the COP26 event in Glasgow having recently put his hand up to lead the the bank's sustainability program. The two main objectives of the program were to reduce so-called "financed emissions" in the bank's loan portfolio while simultaneously helping corporate clients with transition financing to reduce their own emissions footprint. In the absence of real carbon taxes, many of John's corporate clients had started to implement shadow carbon prices in their finance systems which were designed to steer the company away from emissions-intensive activities and products. Many of the low-carbon alternatives were more expensive than the traditional carbon-intensive materials so these internal carbon prices were meant to eliminate these differences. For example, back in 2021 green steel was about 30% more expensive than traditional steel but the companies that implemented internal carbon prices made traditional steel appear more expensive by attaching a 40% virtual tax to them in their finance systems.
Unfortunately not all the big industrial players were playing by the same rules. The companies that chose not to implement internal carbon prices were still able to access the cheaper carbon-intensive process and materials. In fact, traditional steel became even cheaper as demand for green steel rose so the companies that opted for traditional high-emissions alternative were able to operate a higher profit margins than previously. What was missing from the system was real carbon taxes implemented by governments. The companies that had implemented internal carbon prices were effectively taking a bet that carbon taxes would be implemented by governments later which would penalize those competitors that had chosen not to manage down their emissions
This put John's bank in a very difficult position. The carbon-conscious companies were becoming less profitable and losing market share while those companies that were gaming the system were becoming more profitable. By 2030 there were strict regulations in place which forced John's bank to cut their financed emissions in half which meant that the bank had to exit many of their most profitable positions and shift lending to low-emissions companies. John's team had started to refer to these company as "green dream" companies since they had chosen to invest huge sums in cleaning up their emissions but had not received any reward for doing so and were therefore struggling to make repayments on their loans.
A similar dynamic then started to occur in the financial system. As the banks offloaded all their most profitable fossil-fuel related positions, the shadow system (consisting of special purpose vehicles, hedge funds and private capital) started to hoover up the profitable positions making huge gains by investing in the worst-offending companies and industries that the regulated banks and insurers were no longer able to serve.
The writing was on the wall
John flipped open his laptop and opened the report from IPCC climate scientists that had been widely read by the attendees at COP26. His gaze was transfixed on one particular chart:
The scientists had made it very clear that world needed to cut emissions dramatically (following the blue lines above) to avoid a climate catastrophe (associated with the red paths in the chart). But because many companies, financial institutions and countries had profited from continuing their emissions-intensive activities, emissions had continued to grow by 1-2% a year rather than falling. It shouldn't have surprised John then to read the latest news describing how the earth was now locked in to at least 4 degrees warming by the end of the century.
John scrolled a couple of pages further in the document. The predictions that scientists had made 14 years ago had been clear and prescient in equal measures. The earth was warming rapidly and so was John's blood pressure.
Policymakers did too little too late
In 2033, international policymakers finally took coordinated action to put in place carbon taxes that would reward companies that had cut their emissions and penalize those companies that had been arbitraging the rules. However, climate-related events had already started having a devastating effect on the global economy. Floods and extreme heat were already leading to a massive displacement of people, increased conflict and the destruction of physical assets. Bankruptcies of major companies and banks were now commonplace and the global economy was starting to grind to a halt. Commodity prices collapsed just at the moment when world governments attempt to tax fossil-fuel companies meaning they were unable to raise significant revenue. Worse still, any tax revenues that were raised were needed to clean up the mess from the climate-related destruction with insurance companies having lacked the capacity to cover the widespread damage. John did a quick calculation in his head. Imagine if world governments had implemented a $100 per-tonne-CO2e back in 2021. With emissions running at 40 billion tonnes per year they would have raised $4 trillion annually. Surely this would have been enough to fund a smooth decarbonization of the economy? What was it that had caused policymakers to hesitate?
John's company had been on the brink of collapse for a couple of years. Ironically, even though climate was the cause of the problems, the focus had now shifted away from emissions to credit risk. The banks were struggling to find a way to clean up their credit positions without crystalizing big losses. The end came for John's bank when all the other big banks finally pulled their credit lines and Garland Brothers ran out of cash.
The insurance industry had pretty much become irrelevant. As with the pandemic, it was clear that the industry lacked the capacity to cover these massive events which were increasing in size and frequency. The industry was embroiled in long-standing lawsuits for previously disputed claims and many companies had concluded that it was no longer worth it to renew their insurance.
John was angry. He felt like his bank had played everything by the book and done everything it could to help the economy with the transition to lower emissions. But it was now clear, that policymakers should have acted much earlier with carbon taxes. This not only would have rewarded good behavior but would have also raised the funds that were needed to scale green technologies and incentivize new consumer behaviors. John and his clients had done the right thing in implementing carbon prices and in reducing financed emissions but these actions needed to be swiftly backed up by government intervention into the real-world markets.
Very interesting perspective. The Financial Times recently ran a story how activist investors (private capital) are already trying to e.g. make Glencore divest its coal business. Of course, they are giving (questionable) environmental reasons for this, but this fits into your narrative. For now, divesting the 'dirtier' assets of Glencore might make sense from a valuation perspective (although Glencore's valuation seems quite in line with its peers), but if the divested (likely cheaply) brown assets are never penalised, then that investment will have been a bargain.