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Looking At It Both Ways: How Climate Change Threaten Financial Systems?

5 mins read

16 January 2023

It is inevitable that countries must aim for a greener economy but with the world having been reliant on carbon-sensitive assets, devaluing carbon will also pose danger to the economy.

Regulators should pay more attention to climate change and step up their efforts to mitigate it since it poses a systemic danger to the financial sector. Systemic risks in the financial system are dangers that could impair the system’s usual operation and have gravely detrimental effects on the real economy. The physical risks brought on by more frequent extreme weather events and long-lasting environmental changes, as well as the transition risks brought on by the necessary policy and technological changes to attain a greener economy, are at least two categories of climate-related risks that cross this threshold. These modifications might strand carbon-intensive assets and have an impact on other financial instruments’ values.

Physical and transition risks are expected to cause enormous losses, and given how quickly they could occur, those losses could be devastating for systemically significant financial institutions and larger financial markets. It’s important to note that financial institutions actively contribute to the physical and transition dangers of climate change by continuing to finance large amounts of activities that exacerbate the problem.

Physical Risks

Insurers, banks, and other financial intermediaries with direct and indirect exposure to various affected industries and assets may experience destabilizing losses as a result of the escalating intensity and magnitude of destructive floods, droughts, fires, and hurricanes as well as the impeding sea level rise. Stress could spread throughout the financial system if it occurs in a large, intricate, and interconnected financial institution—a corporation with significant systemic importance—or if it occurs in smaller, similarly vulnerable firms.

Because their primary business compels them to guarantee losses on physical goods and property, insurance companies are the financial intermediaries most immediately vulnerable to the physical risks of climate change, at least in the short term. Since historical datasets are proving to be less useful predictors of future underwriting losses, these companies are working to modify their loss models and underwriting procedures in response to a changing climate and severe weather patterns.

This makes the sector vulnerable to significant losses from a single or a combination of natural catastrophes that were either not anticipated or were assumed to be practically impossible. In order to raise enough money to cover potentially devastating losses or to otherwise satisfy the financial needs of creditors and counterparties wanting to lessen their risk to the distressed organization, insurers may be obliged to sell off illiquid assets at fire sale rates. This fire-sale dynamic may cause asset prices to decline, impacting financial institutions that hold related assets and increasing the cost of funding for businesses that depend on such markets.

The physical concerns of climate change also directly affect the basic banking system. Mortgage, commercial real estate, business, and agricultural loans, as well as derivative products linked to these markets, are liable for losses resulting from extreme weather conditions and other environmental changes in various regions of the country. For instance, the severity and frequency of hurricanes, droughts, floods, fires, and other environmental changes may increase, which might reduce the value of affected assets and make it harder for borrowers to pay back lenders, increasing the default rate and losses on these credit portfolios.

Thousands of homes which amount to billions of dollars would actually be submerged if sea levels rose by the projected 6 feet by the year 2100, which would have a negative financial impact on the country. Banks and other financial intermediaries may be even more exposed to physical dangers if insurance firms decide to leave certain regions and business sectors. Banks that are experiencing financial hardship due to greater-than-anticipated losses may be able to spread stress via both the asset liquidation and exposure transmission channels.

Despite the direct negative impact on the value of assets, severe weather events and environmental changes can cause second-order economic disruptions in local or regional economies. According to research, major natural disasters increase poverty rates in impacted towns, cause outmigration, and drop home prices. Additionally, some data suggests that economic output is often higher in colder years compared to hotter years, although recent years have, on average, been warmer. Increased than anticipated losses on the credit portfolios of banks and other financial intermediaries could result from the deteriorating economic conditions in the impacted areas.

Transition Risks

In addition to these direct hazards, the urgently required shift to a greener economy may result in quick losses to carbon-intensive assets, which could collapse the financial system. Carbon-sensitive assets connected to the electricity, energy, transportation, manufacturing, as well as other sectors may lose value if regulators take the necessary steps to decarbonize the economy and if technology advancements enables that move to be commercially appealing.

Such a course of action or innovation might sharply raise the price of carbon, leaving some fossil fuel assets stranded and lowering the value of other assets that are carbon price exposed. One estimate places the present worth of potential losses at $18 trillion – considering all stranded assets as well as those that are directly related to the fossil fuel industry. Up to one-third of all equities and fixed income assets are thought to be connected to carbon-sensitive businesses.

The investors and financial intermediaries who own these assets would suffer losses as a result of their revaluation. A price shock could have an impact on the entire financial system as firms and investors offload assets at fire sale prices, creditors flee from companies that are particularly vulnerable to revaluation pressures, and stressed companies default on their debt obligations or counterparties in derivative transactions. Stress can spread through both the asset liquidation and exposure transmission channels. 

The financial system might become unstable as a result of losses, which would have negative implications on the real economy. This will result in a scenario where asset prices suddenly fall due to the breakdown of the carbon price bubble, resulting in broader financial instability.

Financial institutions and investors may promote this by factoring in the effects of a change to a greener economy over time and modifying their risk management frameworks and models accordingly. This would allow the transition to happen gradually with very little disruption in the financial markets. They might incur some inescapable losses on some assets that are very vulnerable to changes in the price of carbon, but they might also take advantage of fresh chances to fund green businesses. Regulators shouldn’t, however, wager that this hopeful result will materialize without their involvement.

It is the responsibility of regulators to take precautions against the worst-case scenarios so that workers, families, and taxpayers are not made to pay for the regulators’ lack of creativity. In fact, the longer policymakers postpone taking action on climate change, the more possible it is that the economy will rapidly become green and that carbon-sensitive assets would be valued in an unruly manner. A smooth transition would be made possible, the likelihood of a climate-driven financial catastrophe would be reduced, and climate skeptics wouldn’t be able to exploit predicted financial disruptions as an argument against the strict measures required to reach net-zero emissions by 2050.

Financial Regulators Must Act

Financial regulatory measures are intended to reduce the likelihood and severity of disruptive crises by enhancing the financial system’s resilience. Every country’s  financial system needs to be ready to securely address the physical and transition risks posed by climate change, therefore it’s essential for policymakers to take strong regulatory and supervisory action. It may be more likely that policymakers will take the required transitional action if the financial stability effects of a rapid transition are reduced.

Additionally, policymakers should attempt to incorporate climate risk into other facets of the framework for supervision and regulation. Higher risk-weighted bank capital requirements for assets that are sensitive to the price of carbon are all worthy of regulators’ consideration, as are increased supervisory expectations for climate readiness.

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