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

How would we cope with a Cryptocalypse?

Crypto-currencies are one of those features of modern life that tend to polarise people. To their supporters, they represent the future of payments mechanisms, a non-centralised currency in the making, and a means to move away from extractive capitalism by breaking the monopoly over money that the banks hold. To their detractors, crypto-currencies are nothing more than a Ponzi scheme, of no more value than a bag of magic beans. 

The supporters of crypto have been growing in recent times. This has, undoubtedly, been given a boost during the pandemic. A mainly younger demographic, new to investing, bored by living through a sequence of lockdowns, funded by public largesse, have discovered the attractions of casino capitalism. Egged on by investing 'tips' on sites such as Reddit, this demographic has piled into crypto. Today, there are about three times more digital wallets (the means by which crypto-currencies are held) compared with 2018. At this point in time, the supporters of crypto could be right. As could the detractors.

Despite small economies such as El Salvador adopting crypto as legal tender, there have been few signs of crypto replacing more traditional currencies. This is despite the market capitalisation of all crypto-currencies rising from $330 billion to $1.6 trillion in the past year. The detractors ascribe this lack of uptake to one key factor - the widely fluctuating value of crypto-currencies. This rather undermines the use of crypto as a means of exchange. In El Salvador, where Bitcoin is legal tender, prices are quoted in dollars and then converted to Bitcoin at the prevailing rate at the point of sale. The wild changes in the price of crypto also undermines it's function as a store of value and a standard for deferred payments. In the absence of an authority to stabilise the value of crypto - a central bank, in other words - it will continue to fail to perform the functions that are needed from a currency.

If that's the case, what are we left with? All that is left is an asset with little in the way of intrinsic value - it is not guaranteed by a monetary authority or secured by an underlying asset. It is an asset that rests solely upon trust. The investment case for the asset is the 'bigger fool' approach. I may be a fool for investing in crypto, but there is always a bigger fool than me who is willing to buy it from me. This is the dimension that allows the detractors to accuse crypto of being nothing more than a Ponzi mechanism. What happens if the supply of fools dries up? What happens if there is a crisis of confidence in crypto and the demand for crypto assets collapses? In the absence of a central authority to stabilise the value of crypto, in the face of widespread selling of the assets, there is nothing to stop the value falling to zero. What would happen then? Would it matter?

It is useful to divide crypto investors into three camps. First, there are the 'diehards'. These are the true believers in crypto who provide the most ardent support. Second, there are the 'fellow travellers'. These are the investors who see the rising trend of crypto values and who want to participate in this momentum. Third, there are the 'crazies', who simply want the gambling aspect of crypto investment. In the event of a crash, we can expect the diehards to stay with crypto. To sell would represent a fundamental challenge to their belief systems. The crazies would be very quick to leave the market and move on to better things, such as sports betting. For a crash to have a mild impact, the diehards need to persuade the fellow travellers to stay with it. If they can do this - perhaps by replacing the market weight of the crazies - then the fellow travellers will stick with it as their losses would be manageable. If they fail to do this, then the fellow travellers are likely to cut their losses and the value of crypto would fall a very long way, possibly to zero.

The impact of the value of crypto falling to zero would depend upon how long the investors have been in the market. The diehards - who have been invested for more than 12 months - would lose a great deal of unrealised gains (paper profits), but less so in relation to how much they paid for their assets in the first place. The crazies - those invested for less than 3 months - would be likely to be wiped out. If they are leveraged holders of crypto, the losses could well exceed their market capitalisation. The fellow travellers - those invested between 3 to 12 months - would fall in between the two. What is more concerning is that institutional investors (hedge funds, university endowments, mutual funds and a number of companies) are disproportionately situated as either crazies or fellow travellers. These investors are not noted for an overwhelming appetite for risk.

The Economist estimates that the first shockwave of a crypto collapse could be in the region of $2 trillion - about the market capitalisation of Amazon. The secondary impacts are not difficult to see. Loans secured by crypto assets would face calls for liquidity. Leveraged loans to purchase crypto assets would face margin calls. There would be a rush for liquidity leading to investors to cash in conventional assets - firstly financial instruments, and then property assets. At this point a cryptocalypse has the potential to bleed into the real economy. It is likely that interest rates would rise as credit would become scarcer because banks would face difficulties in valuing assets used as collateral in loans. The financial system would start to slow the operation of the real economy, which could lead to a degree of retrenchment on the part of consumers. It is hard to estimate how bad it could get, but it has the potential to give rise to a situation far worse than the financial crisis of 2008.

Of course, this doesn't all happen in a vacuum. The monetary authorities can currently take action to protect the real economy from a cryptocalypse from happening. The crypto system could be isolated from the monetary system by, for example, requiring that collateral on loans within the crypto derivatives market is restricted to conventional cash. The authorities could require the tighter regulation of crypto exchanges. The authorities could insist that crypto holdings are valued at zero in calculations of capital adequacy. There are a whole raft of measures that could be undertaken to make the world safe from crypto. It is comforting that this is the current direction of regulatory travel, even if the pace is a bit slow.

Stephen Aguilar-Millan

© The European Futures Observatory 2021