Impact of Climate Change on the Financial Sector
Climate change is one of the most prominent issues of the twenty-first century which is rapidly spreading its frightening branches and is taking a toll on the functioning of each and every sector of the economy. Even the financial sector is not spared from the catastrophic impacts of climate change. The financial regulators, policymakers, international organisations, and investors are increasingly acknowledging the significant implications of climate change for the financial sector and financial stability of various countries. Broadly, the two main climate-related financial risks that have been ascertained by various researchers are the physical risks and the transition risks. The physical risks pertain to the economic damages of the climate change-induced events. While the transition risks arise due to the changes in the climate policies, technologies, consumer and market sentiment, etc. during the transition to a low-carbon economy.
Broadly, the two main climate-related financial risks that have been ascertained by various researchers are the physical risks and the transition risks.
The banks, that have traditionally considered climate change as corporate social responsibility (CSR), are now increasingly realising the need to deal with climate change as a financial risk. The high financial stakes, growing external pressures, and new regulations in order to confront the impacts of climate change are making the banking sector highly vulnerable. Several studies have revealed that the severe weather events which are caused due to climate change possess the potential to severely damage the lives of individuals and devastate local economies by affecting the national economic output and employment. The decline in the economic growth and the destruction of capital harms the profitability and liquidity of firms and causes severe losses to households which ultimately increases the probability of default on loans taken by them, while also decreasing the value of collateral, thus stressing the balance sheets of banks. The overall result is an increase in credit rationing by the banks which again affects the profitability and liquidity of firms giving rise to a vicious financial cycle.
Banks also have credit exposures to the clients having business models that are not aligned with the transition to a low-carbon economy. These firms are more vulnerable to the risk of reduced corporate earnings and business disruption due to changes in policy, technology, and customers’ sentiments. Companies in the sectors of energy, agriculture, transport, and property are mostly impacted by such transitional risks.
Apart from the acute weather events, structural changes in the climate also cause huge losses along with business disruption for companies. For instance, agriculture businesses face a drop in revenue, rising insurance costs, or disruption in the supply chain due to shifting seasons and lower agricultural yields caused by climate change, thus increasing the credit risk of the client to its commercial lenders.
The fed, in the financial stability report released in November 2020, estimated the possibles financial risks caused by climate change:
The frequency as well as the intensity of extreme weather events like hurricanes, wildfires, rising sea levels, etc., also affect the demand for property in the high-risk areas which equivalently impacts the price of properties in these areas. As per a study by the University of Colorado, the world has witnessed a huge drop in the sales of properties in high-risk coastal areas starting in 2013. The study also states that homes near the seas were sold for 7% less than other comparable homes in the low-risk areas, on average. Researchers at Pennsylvania also concluded that the number of houses sold in the markets with the highest risk of floods fell between 16% and 20% from 2013 to 2018. A 2017 study by Ohio State University also found that due to excessive algae formation which is a result of warmer weather, Ohio homeowners who live near Buckeye Lake and Grand Lake witnessed a decrease in their combined property values by $152 million from 2009 to 2015. The downward price trend of the properties in the high-risk areas stands in stark contrast to the rising prices in the low-risk areas which compels the people with high income to relocate to low-risk areas while the people with low incomes are exposed to high risks of flooding.
The increasing climate-change-induced events also lead to an increase in the insurance costs of the owners of the properties. Various insurance companies are increasing the premiums on the insurance of the properties in high-risk areas which feeds into the rising costs of owning the houses in such areas. Moreover, various reports have also unveiled the possibility of rising property taxes as a result of climate change. As the people migrate to low-risk areas, the tax base in the high-risk areas shrinks, and the municipalities and the governments are constrained to raise the property taxes in order to maintain the infrastructure in such areas.
The extent of risk to the real estate sector can be construed from the following graphs which represent the potential losses to the properties in different cities of the USA by 2045 owing to increased flooding:
At first glance, the effects of climate change may not seem detrimental to property and casualty (P&C) insurers. They can use the annual policy cycle and their sophisticated understanding of evolving risks to reprice and rearrange portfolios to avoid long-term exposure to climate events. And the growth within the value at risk—and possibly volatility—should increase the demand for new and different insurance solutions and services, which, in turn, could expand the industry’s opportunities. Insurers, however, must take care to not underestimate the actual threat of global climate change. Because its effects are systemic, climate risk is likely to stress local economies and, more grimly, cause market failures that impact both consumers and insurers.
The insurance industry is exposed to climate-related liabilities on two fronts: In both its investments, and on the liability side through property and casualty underwriting. As of year-end 2019, the U.S. insurance industry had $582 billion invested in some combination of oil, gas, coal, utilities and other fossil fuel-related activities, a slight increase from $519 billion in 2018, according to research from S&P Global Sustainable1.
Stakeholders, like customers, shareholders, and regulators, are likely to demand that insurance solutions transcend the traditional risk transfer to explicitly address risk mitigation. These risks can be either physical, directly affecting the insurance business, or transitional, affecting insurers’ portfolios as assets are repriced. The insurance industry must act quickly to adapt to the growing threat of climate change.
Institutions like insurers and pension funds are also awakening to the opportunities arising from the transition to a low carbon economy, and are working to enhance the data and expertise they can call on. Nonetheless, few financial institutions would claim that they have mastered climate-related issues, nor that they fully understand the systemic risks they pose to the stability of the financial system. Players throughout the investment value chain are struggling to get to grips with this uniquely complex issue- one made even more challenging by the unpredictability of future political and regulatory responses, and a lack of reliable data. There is much that financial institutions can do to address climate-related risks and opportunities.
Investors can no longer ignore the impact that the world’s changing climate will have on their portfolios, according to a report led by Mercer and supported by IFC, in partnership with Germany’s Federal Ministry for Economic Cooperation and Development and the UK Department for International Development (DFID). The report—“Investing in a Time of Climate Change”—assesses investment exposure to climate risk, estimates the impact on investment returns through 2050, and offers insights on how investors can improve the resilience of their portfolios.
Estimating the impact of climate change on returns, the report concludes that climate change will create investment winners and losers, with the energy sector the most significantly impacted. The coal industry will be the biggest loser, says the study, which updates a 2011 report.
The renewable sector, meanwhile, is expected to be the biggest winner. Depending on the climate scenario that plays out, average annual returns in the coal sector could fall by 26 percent to 138 percent over the next ten years. Conversely, average annual returns in the renewables sector could increase by between 4 percent and 97 percent over the next ten years.
The study shows that effects on returns from climate change are inevitable. However, if we manage to cap the temperature increase to two degrees Celsius, financial returns for long-term diversified investors will not be jeopardized because of investment opportunities created by the world’s transition to a low-carbon economy.
It is discernible from the above analysis that climate change poses a substantial risk to the stability of the financial sector. However, this emerging systemic risk falls squarely within the jurisdiction of the financial regulators and thus, calls for the much-needed awakening of each and every stakeholder of the financial sector by taking steps in order to strengthen the resilience of financial institutions and markets. Waiting too long to act will only add to the likelihood of a climate shock wrecking the financial system which would seriously impair the broader economy. Workers, families, and taxpayers should not have to bear the brunt later for regulators’ failure to act today.
Anushka Sharma and Harshita Sharma are Analysts at IFSA Hansraj
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