Climate change is already a reality. The economic impact of climate change will likely accelerate, though not smoothly. Climate change affects the financial system through two main channels . The second, transition risk, results from changes in climate policy, technology, and consumer and market sentiment during the adjustment to a lower-carbon economy.
In what The Wall Street Journal called the first «climate-change bankruptcy» , rapid climatic changes caused prolonged droughts in California that dramatically increased the risk of fires from Pacific Gas and Electric’s operations. Tighter financial conditions might follow if banks reduce lending, in particular when climate shocks affect many institutions simultaneously. For insurers and reinsurers, physical risks are important on the asset side, but risks also arise from the liability side as insurance policies generate claims with a higher frequency and severity than originally expected. Climate change can make banks, insurers, and reinsurers less diversified, because it can increase the likelihood or impact of events previously considered uncorrelated, such as droughts and floods.
Transition risks materialize on the asset side of financial institutions, which could incur losses on exposure to firms with business models not built around the economics of low carbon emissions. Fossil fuel companies could find themselves saddled with reserves that are, in the words of Bank of England Governor Mark Carney , «literally unburnable» in a world moving toward a low-carbon global economy. These firms could see their earnings decline, businesses disrupted, and funding costs increase because of policy action, technological change, and consumer and investor demands for alignment with policies to tackle climate change. Coal producers, for example, already grapple with new or expected policies curbing carbon emissions, and a number of large banks have pledged not to provide financing for new coal facilities.
The share prices of US coal mining companies reflect this «carbon discount» as well as higher financing costs and have been underperforming relative to those of companies holding clean energy assets. Risks can also materialize through the economy at large, especially if the shift to a low-carbon economy proves abrupt , poorly designed, or difficult to coordinate globally . Financial stability concerns arise when asset prices adjust rapidly to reflect unexpected realizations of transition or physical risks. There is some evidence that markets are partly pricing in climate change risks, but asset prices may not fully reflect the extent of potential damage and policy action required to limit global warming to 2˚C or less.
Central banks and financial regulators increasingly acknowledge the financial stability implications of climate change. For example, the Network of Central Banks and Supervisors for Greening the Financial System , an expanding group that currently comprises 42 members, has embarked on the task of integrating climate-related risks into supervision and financial stability monitoring. In the United Kingdom, prudential regulators have incorporated climate change scenarios into stress tests of insurance firms that cover both physical and transition risks. Efforts to incorporate climate-related risks into regulatory frameworks face important challenges, however.
Capturing climate risk properly requires assessing it over long horizons and using new methodological approaches, so that prudential frameworks adequately reflect actual risks. It is crucial to ensure that the efforts to bring in climate risk strengthen, rather than weaken, prudential regulation. Climate change will affect monetary policy, too, by slowing productivity growth and heightening uncertainty and inflation volatility. Central banks should revise the frameworks for their refinancing operations to incorporate climate risk analytics, possibly applying larger haircuts to assets materially exposed to physical or transition risks.
Financial sector contribution
Most of these investments are likely to be intermediated through the financial system. From this point of view, climate change represents for the financial sector as much a source of opportunity as a source of risk. The growth of sustainable finance across all asset classes shows the increasing importance that investors attribute to climate change, among other nonfinancial considerations. Estimates of the global asset size of sustainable finance range from $3 trillion to $31 trillion.
While sustainable investing started in equities, strong investor demand and policy support spurred issuance of green bonds, growing the stock to an estimated $590 billion in August 2019 from $78 billion in 2015. Banks are also beginning to adjust their lending policies by, for example, giving discounts on loans for sustainable projects. Sustainable finance can contribute to climate change mitigation by providing incentives for firms to adopt less carbon-intensive technologies and specifically financing the development of new technologies. Channels through which investors can achieve this goal include engaging with company management, advocating for low-carbon strategies as investor activists, and lending to firms that are leading in regard to sustainability.
There are concerns over unsubstantiated claims of assets’ green-compliant nature, known as «greenwashing.» There is a risk that investors may become reluctant to invest at the scale necessary to counter or mitigate climate change, especially if policy action to address climate change is lagging or insufficient.
The IMF’s role
An area where the IMF can especially contribute is understanding the macro-financial transmission of climate risks. One aspect of this is further improving stress tests, such as those within the Financial Sector Assessment Program, the IMF’s comprehensive and in-depth analysis of member countries’ financial sectors. Stress testing is a key component of the program, with these stress tests often capturing the physical risks related to disasters, such as insurance losses and nonperforming loans associated with natural disasters. The IMF has recently joined the NGFS and is collaborating with its members to develop an analytical framework for assessing climate-related risks.
Comprehensive climate stress testing by central banks and supervisors would require much better data. The IMF supports public and private sector efforts to further spread the adoption of climate disclosures across markets and jurisdictions, particularly by following the recommendations of the Task Force on Climate-related Financial Disclosures . Greater standardization would also improve the comparability of information in financial statements on climate risks. The potential impact of climate change compels us to think through, in an empirical fashion, the economic costs of climate change.
Each destructive hurricane and every unnaturally parched landscape will chip away at global output, just as the road to a low-carbon economy will escalate the cost of energy sources as externalities are no longer ignored and old assets are rendered worthless. On the other hand, carbon taxes and energy-saving measures that reduce the emission of greenhouse gases will drive the creation of new technologies.