Does climate change threaten financial collapse?

It may appear to be a tenuous link, but it is worth spending some time thinking about the links between climate change and the world of finance, and on how the one could impact upon the other. It is generally accepted that the climate is changing. The atmosphere is warming, with a number of climatological consequences. Some parts of the world are suffering droughts, whilst other are experiencing abnormal levels of flooding. The overall level of rainfall has not changed to a large degree, but the number of rainy days seems to be diminishing. This has resulted in fewer rainy days, but those which do occur have more violent storms dropping larger than average amounts of rainfall in shorter periods of time. As the planet warms further, the Polar ice caps are likely to melt, having an adverse impact upon the levels of the sea. Some areas are likely to be abandoned, with the potential for creating surges of climate refugees. There are few who would dispute this picture. However, perhaps it is worth teasing out some of the consequential impacts upon the financial sector?

The impact of climate change upon the financial sector is likely to be felt from three directions. First, there is the direct impact of climate change upon the business models of existing firms. Second, there is the exposure of the financial sector to the hazards impacts of climate change. Third, there is the risk of wider economic damage that affects the financial sector. In each of these, it is worth examining what the risks look like, identifying the key uncertainties, and thinking about how they might be hedged against.

Climate change is likely to make some business models unviable. These are seen as 'transition risks' as the economy moves from one mode to another. A classic example here might be the move from an oil based economy to one powered by green energy. In this respect, the transition risk lies in the assets of the old sectors becoming stranded - i.e. having their value written down a long way in a short period of time. This, in turn, may lead to those companies defaulting on loans and possibly seeing their share price collapse. Companies in this category are mainly in the oil & gas and transportation sectors. They are currently hedging their position by expanding their green energy operations. It may be that this transition can be achieved successfully, but it is by no means certain that they have the technology and organisational culture to make this change. This is one area to watch.

The physical impact of climate change - heatwaves, drought, flooding, storms, and so on - is felt directly in the insurance markets. This may entail a key change in consumer mindsets because these providers may pull out of certain cover entirely. Flood insurance is particularly at risk here. However, this will have an impact further up the value chain. If flood insurance is difficult to find and expensive to acquire, who would buy a house on a flood plain or a water meadow? In this respect, the land banks of housing developers could become stranded assets if it becomes uneconomical to build on those plots. There appears to have been very little mitigation in this area to date. We shall watch carefully to see how the issue develops as and when climate change becomes more disruptive.

The question of wider economic damage is the least certain area in which climate change can impact the financial sector. No doubt there would be some impact, but whether or not is would be a serious impact is debateable. A number of central banks have conducted stress tests around this, to find a degree of resilience within the financial sector. However, stress tests tend to be a bit one dimensional and fail to capture the full volatility and uncertainty associated with very complex changes. This is the area in which the full impact of climate change is the most uncertain, and where the risks are the greatest. So what can we do? As always, in times of acute uncertainty, we can keep relatively high levels of liquidity - literally rainy day money - and a good capital buffer so that if we hit a bad patch, we can come out the other side. Illiquid and poorly capitalised businesses may suffer in this case.

The fear of disruptive climate change leads us to exaggerate the impact and the costs. If we are to manage these as we move forward into that time, we first need to identify them and take a view on their quantifiable impact. It is unlikely that we shall see the end of humanity. It is unlikely that we shall see the end of capitalism. It is far more probable that we shall muddle through and adapt to change as it comes our way. That confidence ought not to blind us to the risks and uncertainties associated with climate change. It does suggest that the first step is to accept that change is coming and that we now have an opportunity to prepare for it. Climate change does carry the threat of financial collapse, but it is by no means certain that it will occur. It is up to us, through our current behaviours, to prepare for it's onset.

Stephen Aguilar-Millan

© The European Futures Observatory 2021