Moses Amweelo
Physical risks from increased variability and extremity of climatic conditions will reduce the value of certain assets and income streams. Climate change is a significant issue with broad-ranging implications for the economy, the financial sector and society at large.
We see how climate change is already affecting people’s lives in Southern Africa and around the world, and it will keep doing so. The climate will continue to warm, with associated changes in the overall climate sector over the next 20-30 years, largely irrespective of our emissions trajectory.
But our actions over the coming years will obviously affect the ongoing path of climate change. Understanding the implications of climate change is hugely complex.
There are several reasons for this, including technology which is constantly evolving – for example, green hydrogen has gone from being a theoretical possibility to becoming commercially viable over the course of the decade.
Climate change is both a local and a global issue due to factors like geography and industry structure, the impacts of climate change will differ by community.
However, facing these impacts will require collective action and coordination. Fortunately, specialists in many fields are contributing to this research, including scientists, technologists, and economists. The more we understand the insights of other disciplines, the better chance we have of managing the risks and finding the opportunities associated with climate change. Policymakers and investors increasingly recognize climate change’s important implications for the financial sector. Climate change affects the financial system through two main channels: The first involves physical risks, arising from damage to property, infrastructure, and land. The second, is transition risk, resulting from changes in climate policy, technology, and consumer and market sentiment during the adjustment to a lower-carbon economy.
Exposures can vary significantly from country to country. Lower and middle-income economies are typically more vulnerable to physical risks. For financial institutions, physical risks can materialize directly, through their exposures to corporations, households, and countries that experience climate shocks, or indirectly, through the effects of climate change on the wider economy and feedback effects within the financial system. Exposures manifest themselves through increased default risk of loan portfolios or lower values of assets. For example, rising sea levels and a higher incidence of extreme weather events can cause losses for homeowners and diminish property values, leading to greater risks in mortgage portfolios. For insurers and reinsurers, physical risks are important on the asset side, but risks also arise from the liability side as insurance policies generate claims with a higher frequency and severity than originally expected. There is evidence that losses from natural disasters are already increasing. As a result, insurance is likely to become more expensive or even unavailable in at-risk areas of the world.
Climate change can make banks, insurers, and reinsurers less diversified, because it can increase the likelihood or impact of events previously considered uncorrelated, such as droughts and floods. Transition risks materialize on the asset side of financial institutions, which could incur losses on exposure to firms with business models not built around the economics of low carbon emissions.
Fossil fuel companies could find themselves saddled with reserves that are, in the worlds of Bank of England governor Mark Carney (2015), “literally unburnable” in a world moving toward a low-carbon global economy. These firms could see their earnings decline, businesses disrupted, and funding costs increase because of policy action, technological change, and consumer and investor demands for alignment with policies to tackle climate change.
Coal producers, for example, already grapple with new or expected policies curbing carbon emissions, and several large banks have pledged not to provide financing for new coal facilities. The share prices of US coal mining companies reflect this “carbon discount’’ as well as higher financing costs and have been underperforming relative to those of companies holding clean energy assets.
Risks can also materialise through the economy at large, especially if the shift to a low-carbon economy proves abrupt (as a consequence of prior inaction), poorly designed, or difficult to coordinate globally (with consequent disruptions to international trade).
Financial stability concerns arise when asset prices adjust rapidly to reflect unexpected realisations of transition or physical risks. There is some evidence that markets are partly pricing in climate change risks, but asset prices may not fully reflect the extent of potential damage and policy action required to limit global warming to two degrees Celsius or less. Closing data gaps is also crucial. Only with accurate and adequately standardized reporting of climate risks in financial statements can investors discern companies’ actual exposures to climate-related financial risks. There are promising efforts to support private sector disclosures of such risks.
However, these disclosures are often voluntary and uneven across countries and asset classes. The potential impact of climate change compels us to think through, in an empirical fashion, the economic costs of climate change. Each destructive hurricane and every unnaturally parched landscape will chip away at global output, just as the road to a low-carbon economy will escalate the cost of energy sources as externalities are no longer ignored and old assets are rendered worthless.
On the other hand, carbon taxes and energy-saving measures that reduce the emission of greenhouse gases will drive the creation of new technologies. Finance will have to play an important role in managing this transition, for the benefit of future generations.
*Dr Moses Amweelo is a former minister of Works, Transport and Communication. He earned a doctorate in Technical Science, Industrial Engineering and Management from the International Transport Academy (St Petersburg, Russia).