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How climate change could hit the financial sector

16 April, 2019Paul Fisher

Extreme weather events are ever more common, and the seasons are unpredictable. But the impact of climate change goes beyond the natural world. Paul Fisher explains the nature of climate-related risk for the financial sector.

A senior bank risk officer once told me that he only worried about risks that might occur in the next three years.  He thought climate change was a long-term risk and so it wasn’t on his worry list. 
legs-in-flood

He couldn’t have been more wrong.

The long-term risk of climate change

Yes, climate change is a long-term risk in the sense that the level of potential losses – and the business opportunities – for financial institutions are going to be rising over time. 

We are looking for policy changes out to at least 2050 and beyond. So there is considerable uncertainty about the trajectory of global warming – and the level of risks associated with possible outcomes. 

But the general direction seems pretty clear. Risks will increase unless, and until, the world economy can reverse carbon emissions.

Financial losses to date

Meanwhile, there have already been significant financial losses, from the crystallisation of both physical and transition risks. 

In 2012, super storm Sandy hit New York causing tens of billions of dollars of damage, much of it insured. 

In a 2014 report, Lloyds of London estimated that “the approximately 20 centimetres of sea-level rise at the Battery since the 1950s – with all other factors remaining constant – increased Sandy’s ground-up surge losses by 30% in New York alone”.

Sea levels are still rising, at a conservative estimate of 3mm a year.

In 2016, Peabody Energy – then the world’s largest private coal producer – filed for Chapter 11 bankruptcy protection. This was in part because of a shift in US energy policy towards gas. 

There are other examples of significant financial losses to investors from individual stocks collapsing in price after government policy changes.

Long-term risks in the short term

Long-term risks can crystallise at any time. My favourite example is that London will eventually flood if its defences are not rebuilt to a higher level.  Officially, it is estimated that a new Thames Barrier might be needed by 2070. 

But a London flood could happen any year, with the right combination of tides and storms. 

The wet winter of 2013/14 in the UK saw the existing barrier close over 50 times – surprisingly, to create room for the volume of water flowing down the river.

To minimise the costs of climate change – both in mitigation and adaption – we need to take as much action as we can, as soon as we can. 

The later we leave it, the more radical and costly the required actions will be. London should not wait to bear the costs of a flood before investing in new defences.

Some investors seem to think that because their investments are short-dated they are not at risk from long-term pressures. Not so.

The risk in an asset depends not just on its maturity but how quickly it’s credit can evaporate.  If an event happens overnight – such as a physical event or an unexpected policy change – markets can re-price within the day. It wont matter whether one is holding a one month bill or a 30-year bond, if the issuer has gone bust unexpectedly.

Opportunities for growth

Climate change also represents an opportunity for growth in the real economy and for investors who make the right choices. Some have already made higher returns by embracing environmental, social and governance (ESG) considerations into their strategy.

In summary, climate change is a risk to the financial sector that is here with us today. Investors – insurers, asset managers – have already lost money on specific stocks or events.  The risk is not yet appropriately accounted for in many business models. 

That is why financial regulators across the world are now getting on the case.

Paul FisherDr Paul Fisher is a Fellow at the Cambridge Institute for Sustainability Leadership. He was previously a senior official and macroeconomist at the Bank of England for 26 years, including 5 years as a member of the Monetary Policy Committee and Executive Director for Markets and 2 years as Deputy Head of the PRA. He is a member of the European Commission’s High Level Experts Group on Sustainable Finance and was a member of the UK Green Finance Task Force. He holds a portfolio of other roles in finance and academia.