Financial supervisors are increasingly concerned about the links between climate change and financial stability. They are right – If no action is taken now, the economy and the financial system are inevitably heading into a climate-induced financial crisis.
In the scenario of an orderly transition to a carbon-neutral economy, many of the assets associated with the fossil fuel industry will need to be abandoned before the end of their economic life (stranded), at huge cost for the financial institutions which provide financing and invest into fossil fuel companies.
And in the business as usual scenario of unabated climate change, the impacts of a 4°C average temperature increase would wipe out tens of trillions of dollars from our economy, to which banks and insurers are intricately exposed via ever more frequent and extreme climate events. Thus, continued financing of the fossil fuel industry will inevitably result in massive losses for the giants of finance, which have the potential to trigger a financial and economic crisis.
Yet, banks and insurers – the institutions that are of major systemic relevance for the financial system and economy overall – massively underestimate these risks, as recently confirmed by the ECB’s thematic review of banks’ climate and environmental risk management frameworks. Investment in and financing of the fossil fuel industry is still treated as any other type of corporate financing from the risk perspective which means that banks’ and insurers’ capital buffers will prove largely insufficient to cover the losses looming on the horizon.
This situation is profitable for big finance and for the fossil fuel industry. Artificially low capital buffers imply higher leverage which increases the return on capital and benefits of financial institutions, but it also artificially lowers the financing cost for fossil fuel projects. For the citizens as taxpayers, this situation is extremely dangerous as it shifts the cost of a possible future financial crisis triggered by climate change onto their shoulders – in the form of taxpayer bailouts and other forms of help, which the governments will deploy to save financial institutions.
But if financial institutions underestimate climate risk, it is for very structural reasons and this won’t change in the foreseeable future – unless credible regulatory measures are put in place. Despite the financial lobby’s rhetoric in policy making circles, we see four reasons why the upcoming batch of “soft” regulatory measures in the banking and insurance prudential rules – disclosures, climate stress tests, consideration of climate-related risks in strategies and risk management etc. – will not protect them from climate-related risk at the scale required.