Can a "carbon doom loop" be avoided?

The solvency of governments, banks, and fossil firms could become enmeshed in the shift to a low-carbon future

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As climate change gathers pace, it has the potential to birth a new sovereign-bank “doom loop”, a frightful dynamic that could bring financial ruin to lenders and national governments alike.

A “doom loop” takes hold when banks stuffed with their own government’s bonds start to totter as the value of this debt falls. To bail them out, the host government issues more bonds — causing their debt crisis to worsen and the banks holding their IOUs to weaken further.

Last year, European Union governments sold huge amounts of debt to domestic banks to help fund Covid-19 relief measures. Though necessary to stop the pandemic-induced recession from turning into a lengthy depression, if investors lose faith in these governments’ creditworthiness because of their monster debt piles, then the banks could be in for a world of trouble.

Beyond today’s crisis, though, there’s a risk that the shift to a low-carbon economy could trigger another, potentially worse, “doom loop”.

Here’s one scenario: investors stop bankrolling a country’s fossil firms in accordance with their own stringent internal climate policies and external stakeholder pressure. The host government then bails out those fossil firms thought critical to the country’s security and infrastructure, partly in the national interest and partly because it would be politically unpalatable to let them fail.

As the low-carbon transition accelerates, these bailed-out companies need ever-larger amounts of public funds to stay afloat, funded via sovereign bond sales to banks. This debt loses value as the bailed out fossil firms hemorrhage cash, causing the banks to wobble and forcing the government to underwrite their losses, too. This ever-tightening sovereign-corporate-bank nexus eventually leads to cascading credit downgrades and capital flight.

Here’s another possibility: the sovereign bonds of a country with a large carbon footprint are directly blacklisted by climate-conscious investors, shrinking its pool of potential creditors. Constrained demand pumps up the government’s borrowing costs, which causes the country’s deficit to widen, its credit to be downgraded, and bonds to be devalued. Those domestic lenders holding these bonds then lose value, too, forcing a bank bailout.

Do these scenarios sound improbable? They shouldn’t. In fact, certain countries may already be feeling the first effects of a “carbon doom loop”. A sovereign-corporate-bank nexus has already taken hold in Poland, where the government is backstopping coal-fired power plants that can’t find outside funding. Elsewhere in Europe, Sweden’s central bank sold off bonds issued by Western Australia, Queensland and Alberta in Canada because of their high greenhouse gas (GHG) emissions, robbing these governments of a high-profile investor.

Private sector institutions are also changing their behaviour. French insurer Axa, for instance, has used its analysis of the “warming potential” of government bonds to underweight the debt of countries that overshoot a Paris Agreement-aligned path in its portfolio.

Awareness of the transition risks facing sovereigns is growing, too. Last month, Fitch Ratings said those countries that export fossil fuels face “stranded-asset risk”, which would likely lead to ratings downgrades.

Still, it would take a lot for investors to run away from government bonds and catalyse a “carbon doom loop”. In part, this is because of the structural market demand for low-risk assets, as both an investment and as collateral for cash borrowing. Then there’s the liability-driven investment strategies used by pension funds and insurers, which attract them to government bonds denominated in their home currency. 

Even those committed to decarbonising their portfolios aren’t shunning sovereign bonds — yet. For example, last year global investors representing more than $16 trillion in assets exempted “domestic [sovereign] issuance for liability matching” from a new net-zero investment framework

More important than all these, though, is the fact that central banks are avid sovereign bond buyers — especially in a crisis. Following the outbreak of Covid-19, the European Central Bank (ECB) launched a bond-buying programme to get EU member states the funds they needed to weather the crisis. Data from Bloomberg Intelligence projects the agency will own 43% of all outstanding German government bonds and about 40% of Italian debt by end-2021.

If central banks’ appetites for bonds were to change in relation to an issuing country’s emissions, though, then one big safeguard against a “carbon doom loop” would fall. The cracks are already showing — take the above example of the Swedish central bank as proof.

It may not even take eschewing “dirty” sovereigns for central banks to trigger a “doom loop”, either. Recently, the ECB and Eurosystem banks pledged to align their non-monetary portfolios with climate-friendly investment principles. This could further shrink the pool of buyers for fossil firms’ debt and move up the day when they have to take government handouts to survive — thereby tightening the sovereign-corporate-bank nexus.

How to escape the “carbon doom loop”, then? First and foremost, governments should act to avoid a ‘disorderly’ transition, which would likely push hundreds of fossil firms into such distress that bailout or bankruptcy become their only options.

They can also shift their own practices to ensure an ongoing bid for their sovereign bonds among climate-conscious investors. Some governments are already issuing “green sovereign bonds” with this objective in mind. France issued its first such instrument in 2017, and has another 15 billion of sales planned for 2021. Italy, Spain, and the UK are also slated to sell green debt this year.

“Green sovereign bonds” may attract a wider pool of investors then traditional offerings. Their value may also prove more resilient as the economy transitions to net zero, so long as it’s clear the proceeds aren’t going towards ailing fossil firms.

Of course, if a country sells lots of “green sovereign bonds”, it may kill the market for its conventional debt, and that of other countries with economies that aren’t climate-friendly enough to justify “green” issuances.

In this case, the proposed cure to a “carbon doom loop” would end up exacerbating it instead.

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