Economic risk: How climate change affects financial stability

Economic risk: How climate change affects financial stability

What is economic risk and how is it related to climate change?

Sabrina Haumann

Jul 15, 2021

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10

min read

It’s no news that our human behaviour can have tremendous consequences for our natural environment and directly accelerates climate change by burning coal, oil and gas for instance.

But have we ever turned the tables?

In fact, it’s not only our economy influencing the climate but the changing climate is also causing serious economic risks.

Just take a look at the floods in Thailand in 2011, which resulted in over $45 billion of economic losses! Extreme weather events, as a consequence of global warming, are becoming more frequent than ever, threatening the livelihoods of millions of people. According to the United Nations Office for Disaster Risk Reduction, between 1998 and 2017, damage due to climate change incurred economic costs of at least €1.9 trillion worldwide.

After all, many of us are still oblivious about how climate change manifests itself in the world around us already, having serious effects on economic stability. So it’s time to get to the bottom of it all and investigate how our environment impacts our global economy.

Read on as we deep dive into climate risks and the way they are shaking up our economic and financial stability!

The Speed Read:

1. The effects of climate change and global warming are already evident and shaking up our risk landscape. Companies, banks, insurances as well as each one of us are subject to physical and transition risks.

2. These risks impose a threat on economic and financial stability through several channels: they decrease labour productivity, reduce output and growth, disrupt our infrastructure and put pressure on our financial system. Due to these risks we can observe possible losses in our investments and rising inflation rates.

3. It’s still difficult to draw a clear line between climate risks and economic damages because some areas in the world will certainly benefit. More time, data and research is needed to give a concrete answer on how climate risks impact economic stability despite distributional and geographical differences.

Economic risk and climate change: What are climate risks?

Before we are able to define the actual economic risks and damages climate change causes, we have to start at the bottom and take a look at the climate risks we are facing.

Climate change manifests itself primarily through changes in long-term atmospheric mean values (i.e. temperature), intensifying climate variability and the increase in extreme weather events. These enforce so-called climate risks: “the potential risks that may arise from climate change or from efforts to mitigate climate change, their related impacts and their economic and financial consequences”.

Climate risks impose a threat of losses in economic, social and ecological values due to storms, floods, heat waves, etc.

Climate risks are also created by a range of hazards. Some are coming in slowly, like gradual changes in temperature and precipitation, while others can happen very suddenly (think of tropical storms or floods).

There are several kinds of climate risks, with physical and transition risks being the most prevalent.

Physical climate risks

Physical climate risks refer to the kind of risks that arise from the physical effects of climate change and that have the potential to affect the overall economy, financial institutions, businesses operations, workforce, markets, infrastructure, raw materials and assets.

Physical climate risks can either be acute or chronic.

Acute risks include droughts, floods, extreme precipitation, and wildfires. Chronic risks include rising temperatures, the expansion of tropical pests and diseases into temperate zones as well as an accelerating loss of biodiversity.

Transition risks, on the other hand, are the risks associated with the transition to a low-carbon economy. According to the TCFD, transition risks “may entail extensive policy, legal, technology, and market changes to address mitigation and adaptation requirements related to climate change”. Such transitions could mean that some sectors of the economy face big shifts in asset values or higher costs of doing business. Policies stemming from climate deals (e.g. Paris Agreement, Kyoto Protocol, etc.) are needed as soon as possible, because the risk of delaying action to a later point in time would be far worse. Rather, the risk here entails the speed of the transition to a greener economy – and how this affects certain sectors and financial stability.

Climate Risks and their financial/economic impact
SOURCE: CICERO CENTER FOR CLIMATE RESEARCH

But enough for the theoretical background behind climate risks! Now, let’s put the cards on the table: What do climate risks mean for our economy and the capital markets?

To answer this, we first need to look at some basic macroeconomic indicators to see how climate change actually affects the economy in various ways...

Economic risk: How climate change impacts global economic activity  

Decreased productivity

Let’s use a simple example: picking strawberries (because who doesn’t like strawberries?).

Imagine it’s a pleasant 22°C outside and a field worker is picking the berries. It’s quite reasonable to assume that the person is probably getting a lot more work done at this temperature than if it was 33°C degrees instead -- or if it was storming, hailing or raining all day. In economic terms, we can transform the amount of strawberries picked into a simple (or sometimes very complex) concept called “labor productivity”.

Research has shown that rising temperature and rainfall (both potential consequences of climate change) are associated with lower productivity.

Climate Risks and their financial/economic impact
SOURCE: SCIENCEDIREKT

Global climate change will increase outdoor and indoor heat loads, and may impair health and productivity for millions of working people (no matter if working on a field, in a factory or in an office).

So imagine our strawberry picker working under the influence of climate change and experiencing increasing temperatures first-hand. Looking at the graph above, it's self-explanatory that our worker picks fewer strawberries with increasing temperatures. If the local supermarket next door requires a certain amount of strawberries being delivered each day, the worker either has to work longer hours, or a second worker has to be hired. Either way, we face a negative supply shock as the costs the business incurs increase and, therefore, prices rise.

Next to a loss in labor productivity resulting from increasing temperatures, we also need to look at it from a “capital stock” perspective. Property and infrastructure losses induced by frequent extreme weather events mean that less capital stock is available due to the damage inflicted from climate change. Such damage may stimulate replacement investment in the short term, but at the aggregate economy level, it is likely to lower net wealth. Since you need both labor and capital to produce output, we would see a fall in the productive capacity of the world economy. With less capital stock available, workers are not able to produce the output they initially did. So we are back at a negative supply shock -- and with this, rising prices.

Worsened infrastructure

Infrastructure is the backbone of the global economy, supporting our society with essentials such as water, transportation, energy supply, telecommunication, and buildings of public facilities, including hospitals, government buildings and schools. These are generally built with the intention to provide convenience and to improve welfare around cities or countries as a whole. However, infrastructure performance is often disrupted by extreme weather and may have spillover effects to economic sectors.

For example, back in 2012, when hurricane Sandy struck the United States, roads, airports and highways were flooded bringing transportation to a halt. Million households lost access to power, causing massive safety issues. A lot of cell phone towers got damaged, leaving people and businesses offline for days.

As you can see, the climate crisis presents direct threats to infrastructure assets as well as significant knock-off effects for those relying on the services those assets deliver.

Decreased output and growth

While in the short run, damages to the infrastructure may boost investment , once it is recognized that such events are a permanent feature of the environment, expectations of weaker economic growth and income prospects (as well as heightened uncertainty) may lead to people and companies investing less and saving more in the medium term. Trade may also be affected by disruptions to transportation and infrastructure following rising global temperatures. Therefore, we are also facing immense changes in demand and supply conditions.

As seen before, changes in labour productivity feed through directly to global income and output. But also, a common uncertainty about the pace and extent of climate change – as well as humankind’s ability to adapt to it – is likely to translate into increased uncertainty surrounding future potential growth. Research found that if no mitigating action is taken, global temperatures could rise by more than 3°C and the world economy could shrink by 18% in the next 30 years.

Shaken financial system

When looking at the financial sector, climate risks may induce the damage of assets, including real estate, productive capital and infrastructure with consequent property and casualty insurance losses, increases in defaults, and potential financial sector distress -- just to mention a few. A late and abrupt transition to a low-carbon economy could lead to a sudden repricing of climate-related risks and so-called “stranded assets”, which could negatively impact the balance sheets of financial institutions.

What are stranded assets?

Stranded assets are physical assets whose investment value cannot be recouped and must be written off. Their loss of value can be due to regulatory rulings or changing trends in the market that make these assets redundant, not exploitable or obsolete.

Asset Value  

According to a study by the United Nations Sustainable Insurance Forum, the most profound impact of climate risks is the one on asset value and investment losses from stranded assets. To investors, these threats pose both idiosyncratic (that is particular to a specific investment or asset) and systemic risks (the risk of collapse of an entire financial system or entire market). With an increase in the frequency of physical events, people will become more reliant on insurance to cover the potential costs of damage to their houses and cars. As you will read later, this can trigger a domino effect for insurers and might end up creating solvency problems. The study argues that by 2040 the upstream fossil fuel industry will have lost $33trn of its asset value. And investment companies, banks, insurance companies or pension funds having invested in fossil fuels would see a tremendous decline in asset value.  

Banks & Insurances  

An increase in climate-related extreme weather events would put infrastructure at risk, hence affecting banks and insurance companies, and, in turn, raise premiums.

To understand why, imagine the real estate or agricultural sector for a second. Both are particularly exposed to physical impacts of climate change, which could affect owners and farmers on both the asset and liability sides of their balance sheet (since they may encounter tremendous damages in their assets and therefore have to take on debt).

As physical risks rise or become more unpredictable, insurers will most likely increase premiums or stop insuring some risks at all. The implied decrease in coverage leads to increased uninsured losses in the case of a catastrophic event, which could negatively impact the collateral value of properties, leaving banks exposed to higher (credit) risk. Understanding the cost of insurance, the protection gap and the possible spillovers to the banking sector and the economy is crucial for an assessment of climate change’s impact on the economy.

In fact, research found that climate change increases the frequency of banking crises (from 26%up to 248% percent), while rescuing insolvent banks will cause an additional fiscal burden of approximately 5% to 15% of GDP per year and an increase of public debt to GDP by a factor of two in the year 2100.

Did you know: Why is insurance becoming more expensive?

Insurance companies are the financial intermediaries that are most directly exposed to the physical risks of climate change since their main business line requires them to guarantee losses on physical assets and property. As weather-related insurance claims rise, insurance companies have more to pay out, which is why everyone’s premiums increase. In turn, consumers may be more reluctant to get insured after all. The term “climate protection gap” is now being used in reference to the share of non-insured economic losses in total losses after a climate-related catastrophe event. If companies and households are not insured, they may need to foot the bill themselves. In both cases, the consumer ends up paying more

Inflation

Rising inflation is materialising itself already through higher food prices and reduced land availability.

Despite all human provisions to maintain a steady and even increasing food supply, agriculture remains heavily dependent on seasonal weather. Just in the past few years, weather extremes caused significant jumps in food prices, causing social, economic, and political disturbances in both developing and developed countries. According to a 2015 report from the World Food Programme, climate change presents risks to the whole food system, from production, through distribution to consumption. In April 2021, the FAO’s real food price index — which tracks a wide range of products — hit its highest level in a decade.

Climate risks and their financial/economic impact
SOURCE: FAO

While land use change is an important driver of climate change, a changing climate will also have an impact on the productivity of specific areas of land and water.

A rise in temperature could hence disrupt supply chains permanently. In this way, climate change affects agricultural yields (the amount of agricultural production harvested), resulting in higher (and stronger) fluctuations of the prices of agricultural commodities. Here we have to note that yields may rise in some regions of the world (which profit from changing temperatures, at least in regard to agriculture) and fall in others, the overall impact is likely to depend on the location of a country and the sources of its agricultural imports. Unfortunately, long term correlation between climate change and inflation have not been studied enough yet, though clearly conceivable.

Conclusion: How do climate risks impact financial and economic stability?

As a result of climate change, an increase in climate risks can be expected within the coming decades, having very different effects on economic stability. While some countries and sectors will suffer considerable economic damage, some other sectors and regions of the world will certainly benefit. Even if we leave these distributional aspects aside, it is very difficult to calculate an overall economic balance of global warming. Hence, increasing transparency, data and disclosure to price fluctuations and transition risks is needed.

It’s obvious that more frequent or severe extreme weather events or a late and abrupt transition to a low-carbon economy could have significant impacts on the financial system, with potential systemic consequences. It is therefore important to start climate protection at an early stage, as the economic costs will be higher the later it is started. Here, public and private sectors can play a crucial role in accelerating the transition to net zero. This can be done by aligning operations with climate goals or doing regular climate risk assessments. Clearly, climate risk can only be managed with coordinated global policy action.

You as an investor can invest sustainably as this prevents investment assets from becoming “stranded” and is increasingly used as a risk management strategy.

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