Why financial institutions must heed the climate change risks?

"If you really think that the environment is less important than the economy, try holding your breath while you count your money." – Dr. Guy R. McPherson (award-winning scientist, professor emeritus at University of Arizona, and world’s leading authority on climate change) 

Climate change has become the key global challenge of our times, and is predicted to pose huge social, political and economic risks. As per “The Global Risks Report 2020” from World Economic Forum, respondents to the Global Risks Perception Survey ranked climate change and the related environmental issues as the top five risks vis-a-vis likelihood.

Climate change-related disasters have already been rearing its ugly head with impunity in recent years - manifesting through rising global temperature; increased intensity and frequency of heatwaves, wildfires, floods and mudslides; extended droughts; ever-more-ferocious hurricanes, cyclones and typhoons; rising mean sea levels; and the warming and acidification of ocean.

2019 alone had witnessed unprecedented levels of devastating storms and wildfires across the globe - Hurricane Dorian in Bahamas, Typhoon Hagibis in Japan,  Australian bushfire, and Amazon rainforest, California and Siberian wildfires to name a few. Today, in many regions across the globe, average warming has already exceeded 1.5 degrees Celsius above the pre-industrial levels. In fact, globally, 19 of the 20 warmest years have all occurred since the year 2001. Polar ice has been melting at a rapid pace. Today, Greenland is losing ice seven times faster than it did in the 1990s.

Unless concerted and drastic remedial measures on a global scale are taken urgently; in the coming years, climate change related events would massively disrupt livelihoods, contribute to mass migration, engender political instability and conflict, decrease human productivity, negatively affect health, damage infrastructure and property, and destroy wealth.

 Economic impact of the climate change

Climate change would extract staggering economic costs and hurt the global economic growth. For instance, amongst several other challenges, it would spawn increased preventive savings, higher credit spreads, reduced economic activity, severe and forced structural adjustments, and may even lead to severe financial crisis. Energy intensive industries (for e.g. steel and cement) and fossil fuel industry (for e.g. coal, oil & natural gas) may see severe disruptions. On the other hand, carbon capture, renewable energy, and adaptation technologies would gain significantly. For major corporations across the world, trillions of dollars are at stake - climate change may massively disrupt their production, trade & supply chains.

As per Global Risks Report 2020, in 2018, worldwide economic damage and stress from natural disasters totaled USD 165 billion – 50 percent of which was uninsured. Research indicates that for US alone, global warming is costing the economy ~ USD 250 billion per year. Further, as per a report, climate risk exposure has already, over the past 10 years, led the developing countries to incur USD 40 billion in additional interest payment on government debt alone. In fact, such additional interest payments that are attributable to climate change risks is projected to rise to between USD 146 – 168 billion over the coming decade. It is estimated that by the year 2100, rising sea levels could annually cost the global economy ~USD 14 trillion – in case the 2° Celsius warming limit that was decided at the 2015 Paris Climate Change Agreement gets breached.

Climate Change: Impact on financial institutions

In order to combat this looming threat of climate-induced catastrophe, key economies across the globe have been working to enable climate-resilient solutions and reduce their carbon emissions. Consequently, these nations have been seriously considering the gradual, yet drastic, reduction in their dependence on fossil fuels - and instead leverage the new renewable energy sources. To monetarily facilitate such a massive shift, many new financial products and a large amount of capital would be needed – therefore, this creates significant opportunities for financial institutions (FIs).

Conversely, climate change also brings in significant financial risks for FIs. It would considerably increase their operational, market, credit, legal and reputational risks. FIs’ lending, mortgage and insurance businesses; and their derivatives and investments portfolio may witness substantial rise in risk levels. The 2019 bankruptcy of PG&E (California’s largest utility firm), consequent to the wildfires, well demonstrates the increased credit risks for banks from climate change.

As per the taxonomy of climate change risks, initially proposed by Bank of England, there are two broad categories of risks that FIs face: physical and transition.

Physical risk: These arise from the physical effects of increasingly frequent climate-related events such as rising temperature and sea level; recurrent and severe floods, storms, droughts or wildfires; sharp rise in temperature etc. Such occurrences can result in damages to property, infrastructure and land; reduced agricultural produce; deterioration/reduction in water quality/availability; disruption in businesses’ & counterparties’ operations and supply-chain; and endanger employee safety. Ultimately, such incidents would adversely affect FIs’ businesses – either directly or indirectly.

For FIs, physical risks can manifest directly via their exposures to households, organizations, and countries that encounter climate change related shocks. Additionally, the adverse impact of climate change on the broader economy - through supply chain disruption or reduced aggregate demand - would affect the FIs indirectly.  

Physical risks would materialize in the form of heightened default risk of loan portfolios and reduction in assets values. For example, FIs’ mortgage portfolios in coastal areas may see increased credit risk and drop in collateral value – due to reduction in property values resulting from rising sea level, frequent flooding and storm, and property damages.

Transition risk: These are the risks of financial losses emanating from transitioning and adjusting to low-carbon economy in order to combat climate change. Such a transition may involve extensive regulatory, policy, market and technology changes. Policy changes could be, for example, in the form of restrictions on carbon emissions or increased carbon prices. Similarly, market preference may change in due course as more and more households switch to greener consumption. On the technology front, low-carbon technologies (e.g. solar, nuclear, wind, and hydroelectricity) may become more competitive than the carbon-intensive fossil fuels-based energy sources (such as coal, oil, natural gas). 

 This transition to low-carbon economy would ultimately create financial risks for FIs. To elaborate, consider the policy changes that are focused on reducing reliance on fossil-fuel (e.g. through new carbon prices, energy taxes, or emission rules). Such policy changes would negatively affect coal, oil and gas producers’ business - they would face increased production cost, sharp decline in earnings, and depreciation of assets (e.g. oil reserves).

Consequently, FIs having exposure to such fossil-fuels producers or the carbon-intensive industries (such as mining, power generation etc.) would get exposed to significant transition risk. They would become vulnerable to rising levels of non-performing loans; and may see sharp reduction in the value of their fossil-fuels dependent assets (such as stakes in coal-based power plants, or stock in oil companies). Equity markets too would witness significant shake-up – for example, due to massive reduction in fossil fuel related export value or the corporate earnings.

Conclusion

Given their huge ramification for the financial services industry, regulators have been actively focusing on the climate change-related financial risks for FIs. For example, globally, Financial Stability Board (FSB) has warned institutions about the possibly disrupting effect of climate change & established Task Force on Climate-related Financial Disclosures (TCFD), that provides recommendations for organizations to disclose clear, uniform and comparable info about the risks & opportunities presented by climate change. 

Similarly, BoE’s Prudential Regulatory Authority (PRA) became the first regulator globally to publish supervisory guidance to its banks on approaches for managing the climate change related financial risks. France’s national financial regulator (ACPR) and Australia’s banking regulator (APRA) and corporate watchdog (ASIC) are few other examples of regulators that have been emphasizing the need for action by FIs in this regard.

Central banks too across the world - including Fed, European Central Bank, BoE, Reserve Bank of Australia and those of Italy, France, Australia and Netherlands – have been examining the imports of climate change on their monetary policy and focusing on ways to strengthen banks’ resilience against the adverse effects of climate change.  

It is therefore the need of the hour that FIs heed and act urgently on this matter. Afterall, the climate change related financial risks for FIs are too huge to ignore. In another upcoming article, I will share my views on the actions that FIs need to undertake in this regard.