The Catastrophic Climate-Finance Circle

When big banks started failing across Wall Street and the housing and stock markets plummeted in 2008, the world realized how important financial regulation is for economic stability – and how swiftly the effects can cascade throughout the economy when regulators are asleep at the wheel. Climate change has a drastic altering effect on the global economy. Despite Wall Street jokes about the weather being a terrible excuse for bad economic data, climate change is now plainly fast enough to alter economic forecasts. How long until projecting GDP is largely, if not entirely, dependent on projected weather patterns?

These issues are already on the minds of officials. Various government and corporate organizations have attempted to model the economic implications of climate change. Climate change is a significant economic threat today. Once again, how financial regulators and central banks respond will have a big impact on how much it incapacitates the economies. In 2015, former Bank of England governor Mark Carney listed a number of climate-related hazards that might disrupt the financial system. Extreme weather costs are rising, while lawsuits against firms that contribute to climate change are dropping in value.

Nobel Laureate and American economist Joseph Stiglitz concurs. He argued that a sharp increase in carbon prices – which governments levy on companies for emitting climate-warming greenhouse gasses – could spark a new financial crisis, this time centered on the fossil fuel industry, its suppliers, and the banks that finance them, with consequences for the rest of the economy.

Why does Climate Change pose a risk to the financial system? Climate change poses a systemic risk to the financial sector, which necessitates increased regulatory monitoring and mitigating actions. Systemic risks in the financial system are hazards that have the potential to destabilize the system's normal functioning and have major negative effects on the actual economy. At least two types of climate-related hazards cross this threshold:? 1) Physical risks connected with more frequent extreme weather events and long-term environmental changes 2) Transition risks associated with the policy and technology reforms required to establish a greener economy.?

Carbon-intensive assets could be stranded, and the value of other financial instruments could be affected. The massive amount of predicted losses owing to physical and transition risks, as well as the potential for those losses to occur quickly, could have a devastating impact on systemically significant financial institutions and broader financial markets. Importantly, financial institutions are not only exposed to the physical and transition risks posed by climate change, but they are also actively amplifying those risks by continuing to fund activities that exacerbate climate change. Between 2016 and 2018, the six major US Wall Street banks committed over $700 billion to fossil fuel financing. According to a 2016 poll, the top insurers had $528 billion in fossil fuel investments, and the top asset managers had boosted their ownership of assets linked to carbon-intensive industries by 20% in the last few years.

Physical Risk Increases in the frequency and severity of damaging floods, droughts, fires, and hurricanes, as well as rising sea levels, can result in destabilizing losses for insurance companies, banks, and other financial intermediaries with direct and indirect exposure to various affected industries and assets. Stress at a large, sophisticated, and interconnected financial institution—a systemically significant firm—or correlated stress among smaller enterprises all facing the same risks could spread stress throughout the financial system. Between 2016 and 2018, the United States was hit by 45 natural disasters, each costing at least $1 billion. Natural disasters caused an average annual economic loss of around $150 billion over the same time period. In comparison to previous decades, this represents a significant rise in both severity and frequency. From 1980 to 2019, there were an average of six natural disasters per year that generated more than $1 billion in damage, with total yearly natural catastrophe losses of just under $50 billion.

Transition Risk Aside from these physical dangers, the financial system could be destabilized by very quick losses in carbon-intensive assets as a result of the urgently needed transition to a greener economy. Carbon-sensitive assets in the utilities, energy, transportation, industrial, and other sectors could lose value if policymakers took the necessary steps to decarbonize the economy, or if technical advancements made that move financially advantageous. Such action or innovation might dramatically raise the price of carbon, stranding certain fossil fuel assets and lowering the value of other carbon-sensitive assets. One estimate puts the current value of possible losses at $18 trillion, based on a broad assessment of stranded assets, not only those directly in the fossil fuel sector. Adam Tooze, a history professor at Columbia University, estimates carbon-sensitive industries are responsible for up to one-third of all equities and fixed income assets. By enhancing the financial system's resilience, financial regulatory measures are designed to reduce both the likelihood and severity of disruptive crises. It's past time for policymakers to implement bold regulatory and supervisory measures to ensure that the financial sector is ready to securely handle the physical and transition risks posed by climate change. Mitigating the financial stability consequences of a quick transition may also make policymakers more likely to execute the essential transition steps in the first place.

Climate change poses a threat to the financial system's stability, and thus falls under the purview of financial authorities. They must recognize the emergence of systemic risk and take efforts to strengthen financial institutions and markets' resilience. Delaying action will only increase the chances of a climate shock disrupting the financial system and having a significant impact on the broader economy.