Predicting the ebb and flow of the global financial markets can often be likened to gazing into a crystal ball. This outlook becomes even more opaque when climate change impacts are thrown into the mix. One possible future, however, is that the climate transition’s reshaping of the global economy may trigger a global financial crisis.
Signs of this can be seen from the accelerating financial impact of climate change as we inch ever closer to the threshold of 1.5°C from the current warming level of 1.2˚C. Evidence of global warming was further cemented in the first week of July when the hottest average global temperatures were recorded over two consecutive days.
As history shows, the triggering of a financial crisis is not linear process but rather the convergence of many different factors. So too would it be with a possible climate change-triggered financial crisis.
Governments, businesses, and individuals are all having to invest significant resources into activities to adapt to climate change, not least of which include transitioning to renewable energy, building climate-resilient infrastructure, and implementing sustainable business practices. As the climate crisis becomes more pronounced, the potential for these initiatives falling behind becomes critical; not only for the planet, but for investors too. Should this happen, instability in the financial markets may follow, particularly where asset owners/managers have made net-zero commitments. These well-intentioned commitments could, if not carefully managed, have material unintended consequences.
The destruction of infrastructure, businesses and homes seen by the more frequently occurring as well as intensifying climate change-related weather events is adding to this financial burden of adapting to climate change. Not only in terms of the costs associated with rebuilding infrastructure and businesses, but also the likely rise of insurance premiums in the coming years. To the extent that these become unaffordable for businesses or individuals, this could reduce the effectiveness of insurers providing a vital buffer to the financial system.
As the world continues its transition to a low-carbon economy, investors could be forced to shift away from fossil fuels and other so-called ‘dirty’, carbon-intensive businesses. This disinvestment, driven by policy changes may cause assets, many of them globally significant, to become stranded.
Similarly, in the race towards net-zero, some investors may begin dumping shares in companies deemed not to be on track with their decarbonization strategies and, thus, cause significant market dislocations if the volume of sellers significantly outweighs sellers.
The reality is that there is a strong interconnectedness between each of these scenarios and, as such, we could see them play out in tandem. The escalating tension on national treasuries, prime brokers and banks coupled with market devaluations and deepening financial instability is a cocktail recipe for an economic calamity that could have greater ramifications than the 2008 global financial crisis or even the Great Depression.
While the outlook may seem dire, the world does have the ability to avoid, or at least, limit the most extreme impacts of climate change-related financial shocks. Being the largest custodians of capital, financial institutions including pension funds, insurance companies, sovereign wealth funds, asset managers and banks will have a vital role to play.
If financial institutions are to steward the global financial system through what is likely to be an utterly profound enviro-social-economic event, it is incumbent that they fully assess and understand all the risks and opportunities associated. How well positioned is a portfolio to weather a climate-driven liquidity crisis? It is equally crucial that they integrate climate change into risk management frameworks and evaluate the potential impact on their portfolios.
The value placed upon climate scenario analysis and modelling has led to it becoming mainstream within financial services as an effective tool to better prepare the financial system to withstand severe shocks. The recent launch of the first system-wide exploratory scenario (SWES) exercise by the Bank of England, working in conjunction with the Financial Conduct Authority (FCA), is evidence of this momentum. The SWES will improve our understanding of how banks and non-bank financial institutions behave during stressed financial market conditions, with a particular focus on liquidity and how this may change during these periods.
While the question of if, how and when a climate change financial crisis will unfold remains elusive, financial institutions that invest more resources into scenario planning and climate risk management will ensure that they are more prepared to deal with such an eventuality. This is the strength of using climate scenario narratives to understand climate-related risks: “Hoping for the best, prepared for the worst, and unsurprised by anything in between.” Maya Angelou.