The financial sector is not immune to the effects of climate-change-induced physical devastation; nor can it absorb the costs of transitioning to a greener economy, posits Dr Edward Thomas Jones, Lecturer in Economics.
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By Chartered Banker, UK
The G20 forum and the Financial Stability Board (FSB) have both pointed out that climate change is a threat to the stability of the global economy. Studies have shown the link between natural and man-made environmental risks, which include climate change, and economic and financial risks. As former United States Vice President Al Gore might say, there is an “inconvenient truth” that climate change is a systemic threat to financial stability.
More recently, bank losses have materialised due to physical risks and transition risks arising from impacts on the environment. Physical risks include the effect of environmental risks on infrastructure, agriculture, businesses, and individuals. In the early 21st century, the frequency and intensity of hurricanes increased significantly, causing much greater damage to coastal economies, particularly in the Caribbean, the US and Southeast Asia.
One of the costliest natural disasters in American history was Hurricane Katrina, which hit the Gulf Coast states of Alabama, Louisiana, and Mississippi, including the city of New Orleans in 2005, causing economic damage costing at least USD186 billion. The effect of the hurricane led to high loan losses for banks that had exposure to the impacted areas, leading US regulators to review the adequacy of bank risk models regarding credit risk and hurricanes.
Hurricanes haven’t been the only recent natural event to cause considerable financial loss. California’s continuous battle with drought, along with unusually high temperatures and dry vegetation, has contributed to devastating fire seasons. For example, Wang et al (2021) estimate that wildfire damages in 2018 totalled USD148.5 billion, which was approximately 1.5% of California’s annual gross domestic product.
With increasingly severe storms, floods, and fires, many forecasters envision a crisis that pivots from the physical to the economic. The growing fear is that widespread damage to property serving as collateral for loans and to assets underpinning other investments could cause devastating financial blowback to banks. If sea levels rise by six feet by circa 2100, American homes valued at USD900 billion would be underwater according to DeConto & Pollard (2016).
Transition risks arise from adjustments towards a greener economy. Unanticipated changes in climate policies, regulations, technologies, and market sentiment could provoke a repricing of the value of bank assets. After the 2015 Paris Agreement, there was an increased awareness of climate policy risk with banks increasing the cost of credit to fossil-fuel-based firms. There are already examples of central banks being active in recognising the impact of climate change. In 2021, the central bank of Sweden (the Riksbank) cleansed its reserves of assets tied to pollution and started mapping the carbon footprint of its corporate bond-purchase programme. The People’s Bank of China has provided direct investment in sustainable projects, encouraging the sale of green bonds. The Bank of Japan is looking to spur private-sector efforts by providing funds for bank lending to climate-friendly businesses. Policymakers at the Bank of England have signalled they will take account of the government’s environmental goals when buying assets in financial markets. However, the same trend hasn’t been seen in the US. In January 2023, Chair of the US Federal Reserve Jay Powell said the Fed would not become a “climate policymaker” as he mounted a vigorous defence of the US central bank’s independence from political influence.
Most regulators are established by primary legislation and have specific legal objectives, and it is almost unheard of for that legislation to mention climate change. But some regulators have now adopted sustainability as a secondary objective. Governments continue to be the driving force, but there are increasing cases where they have asked their regulators to consider climate change when performing their primary duties.
Climate change represents a material business and financial risk to the financial system, its users and the real economy. That means that regulators must take the issue into account, even without any extension to their responsibilities. Regulators don’t usually have explicit responsibility for allocating capital towards socially useful ends. Governments do, and they use a variety of tools to achieve their aims: legislation, taxes, subsidies, etc. However, regulators can indeed facilitate the reorientation of financial flows necessary for addressing environmental risks if, for example, their governments asked them to enforce climate-related financial risk disclosures. But, in doing so, the regulator may find itself walking a tightrope, having to balance exaggerated expectations against limited capabilities and political economy constraints.
The FSB’s key climate change roadmap (see the 2021 FSB Annual Report), called for regulators to collect better climate-related data from the financial sector, to perform analysis of financial institutions’ vulnerabilities to climate change, and to monitor those risks. Other financial regulators, notably within the EU, have proposed greater measures to tackle environmental risks. These include creating ‘green supporting factors’ to give preferential regulatory treatment for the financing of environmentally friendly projects or ‘brown penalising’ ones that have the opposite effect.
There is a growing awareness that climate-change targets cannot be achieved without input from players in the financial system. By facilitating the financing of low-carbon activities, a green transformation of the system could not only contribute to the fight against climate challenges, this could also protect it from climate-related financial risks.
This article previously appeared in the Chartered Banker magazine, UK, Spring 2023 edition.