When Black Swans Turn Green

The coronavirus (Covid-19) is the latest black swan to blight the financial markets. But it’s not only black swans that treasurers need to recognise the importance of – grey and green swans are equally deserving of attention.

In his 2007 book The Black Swan: The Impact of the Highly Improbable former options trader Nassim Nicholas Taleb discussed the effect of rare and unpredictable occurrences that have extreme impacts and how, with hindsight, people tend to look for simple explanations for them. This is the definition of a ‘black swan’ event.

But now we’re talking about ‘green swans’ – a kind of ‘climate black swan’. These could be the most dangerous of all because of their tendency to be exceptional, unpredictable and sudden. Of course, a ‘natural’ catastrophe is not always foreseeable: think of the 2011 earthquake and tsunami off the Pacific coast of Tōhoku and the subsequent Fukushima Daiichi nuclear disaster, and other earthquakes, especially in Turkey in January this year and in Italy in 2017.

Climate disasters could have cascading consequences and set off chain reactions with unpredictable effects. The speed with which they materialise is often greater than expected, if they are expected at all. Their consequences could be more disastrous than any systemic financial crisis, since they could threaten all humanity, as some climate scientists predict.

In the same way that the potential magnitude of an earthquake is unknown until after the event, so too are the consequences of Covid-19. Some of these consequences will be unpredictable and the indirect effects significant. Indeed, Covid-19 meets the definition of a black swan in that it is rare and unpredictable.

Other swans, other times

The 9/11 attacks of 2001 or an atypical climatic feature are also examples of these black swans. But it is also important to consider the arrival of the grey swans; they represent a kind of middle ground between the norm and the exceptional. Grey swans are more predictable than the black ones but they still have a significant impact. The current Sino-American trade war could be a ‘grey swan’, if it escalated.

It is also worth noting that the Bank for International Settlements (BIS) has just published a report together with the Bank of France entitled The Green Swan. Central banks are concerned about the unavoidable effects that climate-related disasters have on the global economy and finance.

The risks associated with green swans fall into two categories. The first is the physical risk, namely the natural disaster that does the damage. For example, the San Andreas fault, which could open up and cut California in half. Every type of business and millions of people would be affected both at the time and for years to come.

The second type of risk is the risk of change. For example, certain sectors would suffer from the change to a low-carbon economy. The recent valuation of American electric vehicle and clean energy company Tesla stands at $164bn, which is more than the $104bn combined value of General Motors, Ford and Fiat Chrysler. This reflects the enormity of the effect of some changes.

The abandonment of fossil fuels will certainly have a negative impact on some businesses and individuals and benefit others. It may be an opportunity, but at what cost? These necessary business changes could, if the change isn’t handled properly, cause the collapse of a significant number of companies. The necessary regulatory pressure could sink businesses that are inert or inflexible and, as a result, unable to adapt.

According to the governor of the Bank of France, François Villeroy de Galhau, the increase in frequency, magnitude and intensity of particular weather events could lead to colossal and irreversible financial losses. Catastrophes such as those we usually see only in disaster films will become all too real. Central banks are beginning to incorporate climate risk into all their forecasts.

Many people consider that central banks will be the last bulwarks to save the world economy, but if we know there is always something or someone behind us to help in an emergency, we are more likely to let our guard down. That is when we become vulnerable.

The last defences

Looking back on my years as an enterprise risk manager I can honestly say that in the past, depending on the industry, there were very few attempts to address climate risk. But things are changing, and the recent annual surveys carried out at the World Economic Forum (the Davos summit) show that CEOs now rank them high on the scale of major risks. I want to highlight two significant statements: “Climate change is striking harder and more rapidly than many expected,” and “Climate-related issues dominated all of the top-five long-term risks in terms of likelihood.”

And while central banks are often considered the bulwarks of last resort, we need another backstop to cope with the impact of green swans – and grey and black swans, for that matter. Wealthy countries such as the United States will play their part, but the global economy must also adapt, according to regulatory frameworks, to avoid the domino effect.

Globalisation has removed all barriers: a pandemic originating in China or a tsunami which creates havoc in Japan can have effects far beyond national borders. Shortages of some products, such as electronic components or iPhones, that result from such disasters are collateral, or indirect, damage. Green and black swans have similarly drastic effects but the duration and chain reactions of the green ones are more serious. The prediction of a black swan disaster is not as easy or straightforward as that of a green swan disaster, which can sometimes be forecast. Few people predicted the sub-prime crisis although there had been some indications of disaster.

The green swan may be unavoidable because financial considerations often dictate behaviour that is contrary to what is really needed. We could stop using fossil fuels earlier, close coal mines, choose vehicles with less CO2 emissions or change our climate footprint altogether, but irrational hope slows the pace of preventative solutions – we think we have time – until it’s too late. The melting of glaciers is a prime example of this and may now be irreversible. An economic crisis is unlikely to affect the climate or directly kill people, whereas a climatic crisis can have serious and long-term material and human consequences. Certainly, regulation can help prevent both types, but in each case part of the solution lies in behaviour, culture, approach and common sense.

‘The only certainty is uncertainty’

What is often important for the market is the narrative behind an event. Look at the S&P 500 Index, which has fallen by nearly 4% since the beginning of the year, and Nasdaq’s dive of 8% due to the Sino-American trade war. Add to the mix tensions between the United States and Iran and the dips could deepen.

Will the coronavirus have a deeper impact on the economy? Although we can’t yet be certain, we are told that the pandemic could cut European car production by 115,000 units (source: Goldman Sachs). If that does occur it would be a clear, measurable result of the pandemic. There is greater risk in underestimating than overestimating the consequences of such a crisis.

No insurer or reinsurer will deny that the magnitude and frequency of climate-related catastrophes is increasing, and there is a fear that the upward curve will steepen too quickly. Without insurers, or with premiums that are too expensive, the global economy will falter. You wouldn’t drive without insurance, but maybe one day you won’t be able to insure your building if it is on the coast or close to a seismic fault; the material and financial consequences of a lack of insurance in that situation, without a safety net, could be appalling.

Let’s not forget the risk posed by swans of any colour. According to the author Ian Kershaw, “Europe may well experience new fractures. The only certainty is uncertainty. Insecurity will remain the hallmark of the global age.”

Although I can’t predict the colour of the next swan, I do fear that sooner or later we will have to face a crisis and perhaps the dominant colour will be green. But in conclusion, let’s keep in mind my favourite quote from the French poet, dramatist and diplomat Paul Claudel: “The worst is not always certain.”