Saturday, June 19, 2021

Reposting: "Climate Change & its Impacts on the Financial Industry"

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The folks over at The Justice of Diversity, Equity & Inclusion have posted a short essay well worth considering:  Climate Change & its Impacts on the Financial Industry. The essay reminds us of the strong interlinking between the operational and financial sides of economic activity, especially those that leak across borders. More importantly it reminds actors, especially those in the financial sector, of the close association between the metrics of risk and the objectives of sustainability, including climate change.  
Indeed, the realities of both suggest that the traditional approaches--qualitative and grounded in policies better known for the loftiness of their discursive structures than their capacity to be transposed into  everyday decision making in which climate risk is deeply embedded in all aspects of operation--require reworking.  That reworking might most usefully target the context and forms of decision making essential to the work undertaken by an enterprise.  And that, in turn, requires the incorporation of climate risk in business decision making.  For financial sector enterprises--banks, insurance and re-insurance enterprises and states in the business of guaranteeing investment in foreign states undertaken within a BIT framework--the incorporation of that risk would affect decision making in three respects.  First it would substantially affect (or ought to affect) the way that financial services are priced. Secnd, it ought to affect the baselines below which transactions are rejected as uneconomic because of their level of climate related risk. Third, it ought to substantially affect the way that such financial instruments undertake the management of their relationships with their clients.  That, in turn should take two forms; firstly, it should produce some changes in the standard covenants of such agreements, and secondly it should incorporate a robust system of reporting and accountability throughout the life of the relationship.  

These changes should transform the quality of the relationship between financial enterprises and their clients (including again states which are effectively involved in financing through their guarantee and subsidy mechanisms). However, they do not require changes in the culture of financial transactions that remain rooted in risk assessment, the protection of the interests of the financial services enterprise, and the need to ensure robust compliance mechanisms already well in place. To meet the challenges of climate change, companies need not change their forms of operation; they need only change, to update, the definitions and accountability (including its pricing) of risk to incorporate climate related risk. To fail to change with the times is bad business (Climate Change and U.S. Financial Regulators: Overview and Recent Actions).
The reposted essay follows.  




Climate Change & its Impacts on the Financial Industry

For the industry in which I work and most related financial institutions, the two biggest risks that climate change pose are physical and transitional.

Climate change creates financial risks by increasing the frequency and intensity of inclement weather/natural disaster/calamity. There have been many projections that climate change will have profound effects on the US economy and financial system.  We’ve already seen those effects in real-time: the raging fires sweeping across the West Coast, the extreme cold in Texas, damaging not only physical infrastructure but faith in the political and social systems that support its citizens.

COVID-19 has made it clear that preparation is key to addressing the systemic risks that are currently present.  For every one degree Celsius increase, the combined value of market and nonmarket damages across the U.S. economy is about 1.2% of gross domestic product. Globally, by the year 2060 almost 3% of GDP will be the result of damages from climate change.

Business and supply chain disruption will inevitably result in loss of revenue, as well as increase in costs to recover from disaster. In addition, this can lead to lower household wealth overall, which would translate to financial risk and losses to product lines.

When we urgently need to transition to a greener economy, carbon-backed assets like fossil-fuels and coal might be revalued, which could increase the price of carbon drastically and stranding the value of other assets. This will place great strains on the intermediaries holding the assets; a price shock will cascade across the financial system as assets are offloaded, creating real financial instability.

Also as a result of extreme weather, mortgage/commercial real estate loans/derivatives portfolios/and other investments could be impacted. Communities that are economically vulnerable will be especially burdened and unable to recover, which could lead to undermining output and reducing the already dwindling household income. There may be increased default rates/reduced lending/devalued assets etc.

This is a systemic risk, so we should bolster the resilience of our foundational and the supporting systems–which means we should reach out to policymakers to discuss opportunities to mitigate risks affecting financial firms and the broader economy.

The transitional risks that are due to climate change are a little more subtle.

Understand that there is potential of providing financing to activities that perpetuate and intensify climate change, thereby further increasing risk. As we transition and pursue new business opportunities, we should be acutely aware of the new strategic risks that will likely be introduced as our market exposures evolve. As our role as a financial intermediary, we have important relationships with and investments in companies whose operations may do more harm to the environment than good. We should be able to identify, measure and monitor the climate-related risks in our partner relationships.

Globally, many central banks are focusing on how financial institutions disclose climate change risks. In the EU and Asia Pacific, these issues have been discussed for years,(roundtables, council meetings, general assemblies)1 whereas the U.S. is a bit further behind. In 2017, the Network for Greening the Financial System (NGFS) was established by eight central banks and is an international group of financial regulators that works to integrate the risks of climate change into their respective financial systems.

Because the physical risks will cause the need for transition to a new, more stable green regime, the financial system will be destabilized if policymakers do not take the required action to decarbonize the economy before we get to that point. The longer legislators wait to tackle climate change, the more likely a disorderly and rapid revaluation of carbon-sensitive assets becomes. Rather than the transition happening gradually with little disruption to the market, allowing firms to slowly adjust their risk models and price in the effects of a greener economy over time.

We should help encourage policymakers to mitigate the financial risks of climate change by taking the necessary transition steps to a greener economy before we are forced to as a result of crises.

1Hsiang, S., et al., Estimating economic damage from climate change in the United States, Science, June 30, 2017, 356(6345), 1362-1369.

2 Lanzi, E., et al., Economic interactions between climate change and outdoor air pollution, The Organisation for Economic Co-operation and Development, July 2, 2019.

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