Why should we be concerned?
The risks that climate change poses to financial stability are often split into two types. First, there are the direct losses due to climate affects – the physical risks. These might be dramatic events such as floods, fires, heat waves, etc., or more drawn out events, like gradual desertification, that harm the economy in certain places. Perhaps the most obvious way these risks might threaten financial stability is through large insurance pay-outs that put insurers in financial difficulty.
There will also be losers and winners from the dramatic changes that our economies will undergo, whether we start to address climate change immediately or we leave it to later (what the ESRB calls a “hard landing”). These risks are often labelled transition risks.
Take, for example, exposure to firms that rely on fossil fuels. This is well explained by Change Finance: ‘Even if governments do step in, many of the assets our banks, insurers and pension funds rely on could rapidly become worthless. Because the vast majority of the world’s remaining fossil fuel reserves cannot be burned if climate change is to be kept within 2C, the value of any financial assets backed by these fossil reserves is at risk. As the inevitable transition to a low-carbon economy happens, there is a high possibility that the value of such “stranded” assets in people’s investment funds and pensions will diminish or become zero, affecting millions of people’s retirement plans. Investment industry leaders have brushed off this “fossil bubble” saying that they’d sell out of unsustainable stocks when the time comes. But just as in the case of the 2007 U.S. housing crisis, when there were more sellers and fewer buyers for these financial products, the public is always the one that pays.’
It is clear that regulators and supervisors are not moving fast enough. Meanwhile, climate change itself is moving faster than the scientists predicted even a few years ago. The effects are likely to be broader and harder to predict than in the current modelling. While acknowledgement of the problem has begun, very little is being done by regulators and supervisors to actually monitor and change the exposures of banks and financial institutions.
A study by the Green European Foundation found that exposure of the EU financial sector directly to high carbon assets was over €1 trillion. They found that: “Equity, bond and credit exposures of EU financial institutions to firms holding fossil fuel reserves and to fossil fuel commodities are substantial. The total estimated exposures are approximately €260-330 billion for EU pension funds, €460-480 billion for banks and €300-400 billion for insurance companies.” And that is just to carbon assets. But more than just carbon assets will be hit. Battison et al show that the global financial sector equity exposure to a broader set of ‘climate-policy-relevant sectors’ amounts to $32.4 trillion.
The way our financial system works makes these exposures even more dangerous than they seem. The real danger to financial stability comes from the over indebted financial system dominated by too-big-to-fail banks, shadow banks and others. In the financial crisis of 2008, a relatively small loss on US housing assets was amplified. It spread throughout the system to cause a global crisis and a decade (and counting) of economic pain. Nothing fundamental has changed about the financial system since then. The same is likely to happen with losses on stranded assets and other climate change related losses.
What should we change?
Obviously the most important thing that society needs to do is to tackle climate change itself. A part of this will be to change the financial system so that we change how we provide for our needs right across the economy, from climate action to housing to education and health. Right now, the incentives of the financial system are among the key direct causes of our social and environmental crisis. But in addition to these changes we need prudential rules to stop financial collapse from further impeding our efforts to avert catastrophic climate breakdown- and to stop the costs of financial collapse being borne, once again, by the public. You can find more detailed policy ideas elsewhere on the Finance Watch website and on the Change Finance website.