This post is the latest in our special issue: “Climate Change and Financial Markets – Risk, Regulation, and Innovation.” To learn more about the special issue and the work of the Global Financial Markets Center around climate change and financial markets, please read the special issue’s introduction here. And to review all The FinReg Blog posts that touch on climate change, go here.
The risks that climate change poses to the financial system fall under two broad buckets: physical risk and transition risk. Physical risks are easier to conceptualize, and can be categorized as either “acute – if they arise from climate and weather-related events – or chronic – if they arise from progressive shifts in climate and weather patterns.” Transition risks are more nebulous, yet potentially more destabilizing in the long-term. Transition risks arise in the move towards a low-carbon economy, and can be transmitted through declining energy and commodity prices and the myriad financial instruments tied to these prices.
Many assume that transition risks will be driven by government policies, such as the proposed “Green New Deal” in the U.S. Should the transition to a low-carbon economy occur over a long enough period, the financial sector will have time to adjust and the systemic impact will be dampened. However, should the transition occur suddenly and rapidly, perhaps driven by mass political protest, financial institutions could find themselves exposed to a range of fossil fuel assets that are effectively worthless – so-called “stranded assets.”
Recent events have provided an alternative scenario for the catalyzation of transition risks, one driven by government inaction as opposed to government action. The collapse in oil prices driven by the COVID-19 pandemic has put unprecedented stress on an industry that was already overleveraged. In the first quarter of 2020, Exxon Mobil Corp. posted its first quarterly loss in three decades and Royal Dutch Shell PLC cut its dividend for the first time since World War II. At the end of June, fracking giant Chesapeake Energy, who as recently as 2013 had as much debt as Exxon and Chevron combined, filed for bankruptcy. The situation is unlikely to improve when second quarter results are released and, as a recent headline said, bankruptcy looms over the U.S. energy industry.
It remains to be seen how current stresses in the energy sector will impact the financial system. According to one report, “Canadian, Chinese, European, Japanese, and U.S. banks have financed fossil fuels with $1.9 trillion since the Paris Agreement was adopted (2016–2018), with financing on the rise each year.” Should the world economy continue to operate at less than full capacity for some time, which appears likely, it is only a matter of time before problems in the energy sector infect financial sector balance sheets. However, the spread of this infection may be slowed by government actions designed to prop up the energy sector.
On April 30th, the Federal Reserve Board announced they were expanding the scope and eligibility of the $600 billion Main Street Lending Program (“MSLP”), which was originally designed to provide credit to small and medium-sized businesses. Senator Kevin Cramer of North Dakota praised these changes as more “arrow[s] in the quiver” to help the oil and gas industry weather the crisis.
Before the expansion, the MSLP term sheet prevented loan recipients from using the funds to pay off existing debts, but in April, a group of GOP Senators from Appalachian states criticized the restriction, arguing that “the limitation on using loan funding to repay debt” would render the MSLP useless to most Appalachian natural gas companies. The Senators argued that many oil and gas companies (which are typically highly leveraged) would have no way of paying off their debt obligations coming “due before this health crisis is expected to subside.” In early June, the Federal Reserve (the Fed) modified the program’s criteria, removed the restriction on paying off debt, and raised the leverage limit for eligible borrowers. In addition, the Fed expanded MSLP eligibility to firms that have either fewer than 15,000 employees (increased from 10,000) or less than $5 billion in 2019 annual revenues (up from $2.5 billion). Both of these changes were a victory for highly indebted oil and gas companies that were too large to benefit from the small business focused Paycheck Protection Program and too small to benefit from the Primary Market Corporate Credit Facility.
The fossil fuels industry is benefiting – to the tune of billions of dollars – from additional monetary and fiscal policies, including generous tax breaks in the CARES Act and Federal Reserve bond purchases through the Secondary Market Corporate Credit Facility. Oil companies claimed more than $1.9 billion of CARES Act tax benefits through a provision that permits firms to carry back their losses up to five years from taxable years 2018, 2019 and 2020, thereby allowing them to lower taxable income when the tax rate was higher (35%) before the Trump tax cuts in 2017. Energy Secretary Dan Brouillette called this provision an “important liquidity tool” for the oil industry.
On June 28th, the Federal Reserve revealed that it had purchased $17.5 million worth of energy sector bonds – including bonds issued by Chevron and Exxon Mobil – with some bonds not maturing until 2025. It also purchased $19.5 million worth of bonds in the utility sector. These purchases were made on the open market through the Fed’s Secondary Market Corporate Credit Facility. In all, purchases in those two industries make up roughly 20% of the Fed’s individual bonds purchases to date. Of the 800 companies targeted by the Fed for individual bond purchases through this program, 238 are in the energy and utility sectors.
Amazingly, the federal government may take additional measures to support the oil and gas sector, including: tariffs, purchasing oil, and taking equity stakes in oil producers. President Trump himself vowed that he would “never let the great U.S. Oil & Gas Industry down.”
The economic pain felt when the oil and gas industry suffers is real. These firms employ millions of people and support local and regional economies. But, the long-term economic pain current and future generations will feel if we don’t take steps now to reduce our dependence on fossil fuels is far greater.
Rather than allow capitalism’s creative destruction to play out unimpeded, our government and central bank are taking aggressive measures to prop up an industry that is destroying our planet and, in the process, our economy. What incentives do banks and investors have to reduce their exposure to this industry when every time oil prices fall, the government comes rushing in with some kind of bailout?
But, the political winds are changing, and younger generations will no longer tolerate inaction on climate change. Therefore, the next time the fossil fuel industry is in dire straits, government support may not be so forthcoming. Such a scenario casts a new light on transition risks, which has thus far been examined through the prism of deliberate policy choices that would wean us off our dependence on fossil fuels. However, an exogenous shock to the energy sector, like a pandemic, coupled with government inaction – which is itself a deliberate policy choice – could accelerate transition risks and potentially destabilize the financial sector.
Lee Reiners is a Lecturing Fellow at Duke University School of Law and the Executive Director of Duke Law’s Global Financial Markets Center.