What we do today to tackle the mounting global warming crisis will define the world for generations to come. As the planet is getting hotter, extreme weather events become more common severely undermining global economic prospects. Transition to the low carbon world, on the other hand, requires careful management to preserve the foundations of the global financial order.  Scientists, governments and businesses are working together to understand and mitigate the risks arising from climate change, as well as harness the opportunities that the transition presents.

Ever since the Industrial Revolution started gaining pace in the United Kingdom in the middle of the 18th century – bringing efficiencies into the manufacturing process and enabling mobility on an unprecedented scale – the world has been heading towards destructive warming of the planet.  The scientific consensus is that the economic growth over that time resulted in the global surface temperatures rising by 1°C compared to the pre-industrial levels. 

According to the Internal Displacement Monitoring Centre, a part of the Norwegian Refugee Council, natural hazards displaced around 265 million people between 2008 and 2018, with 87% of movement caused by weather-related events, such as floods and droughts.  This is three times higher than the number of people fleeing conflict zones and more people face the risk of losing their homes in the future as planet heating triggers more extreme events . 

Policymakers are warning that insurance and economic losses resulting from weather-related events are likely to grow as share of GDP, putting unprecedented pressure on the financial services industry.  Munich Re’s NatCatSERVICE estimates that the number of natural catastrophes increased from 249 in 1980 to 848 in 2019 with the overall economic losses peaking at US$350 billion in 2018 .  As Morgan Stanley’s Chairman and CEO James Gorman eloquently put it: ‘If we don’t have a planet, we’re not going to have a very good financial system’ .

An Existential Risk of Systemic Proportions

Scientists have a stark warning that it is our actions today that will determine the global warming’s trajectory, either limiting or exacerbating its impact.  The United Nations Intergovernmental Panel on Climate Change estimates global economic damage to reach US$54 trillion by the end of this century if temperature rise is limited to 1.5°C and US$69 trillion if it is kept under 2°C .  Calculations are based on an ‘optimistic’ scenario since, without any measures to cut carbon emissions, the warming is predicted to approach 4°C above pre-industrial levels by 2100.  The ensuing economic damage will be devastating with some scientists estimating US$551 trillion losses.  To put these numbers into context, total global GDP in 2018 was ‘just’ US$85 trillion . 

Risks associated with the physical exposure to natural hazards and the world’s transition towards a low carbon economy are major concerns for the financial services industry.  Insurers are already grappling with the effects of climate change: In 2017, the second costliest year on record, insurers faced US$134 billion in losses from natural catastrophe events .  The winter just gone saw ravaging fires across Australia as well as destructive floods in the UK with devastating consequences for local communities.  With insurance policies subject to regular renewals – which enable insurers to respond quickly to the changing nature of the physical risk – consumers may quickly find their premiums rising to unaffordable levels. 

The change has a much broader socioeconomic impact, however.  Some properties may simply become uninsurable which will put downward pressure on their prices and transfer associated financial burden back to their owners.  Mortgage providers will feel the pain through higher default rates and holding security well below the loan value.  A recent report by a management consultancy firm McKinsey & Company, which looked into the physical aspects of climate change, uses the prosperous area of Florida in the US as an example.  Absent any climate change adaptation, it says, coastline properties – that are already vulnerable to flooding – will see increase in damage and ensuing financial loss. The report estimates that exposure to floods could devalue affected properties by US$30 billion to US$80 billion – or 15% to 35% – by 2050 .

The financial sector will be instrumental in promoting smooth and timely climate change mitigation through supporting transition to the low carbon economy and infrastructure that underpins it.  The landmark Paris Agreement, adopted in 2015 by 195 nations, made a commitment to keep temperature rise this century well below 2°C above pre-industrial levels as well as pursue efforts to limit it further to 1.5°C .  This requires ambitious reduction of carbon emissions by about 45% over the next decade from the 2010 levels so that the net zero objective can be met by 2050.  Large scale reallocation of capital will be necessary to support this fundamental transformation of modern economy:  According to the OECD estimates, the world will require €6.35 trillion a year to meet Paris Agreement goals .

Risks associated with this structural shift – particularly if it happens too late and therefore too fast – threaten the industry’s financial stability.  Adoption of climate-friendly policies by governments and investment shift towards cleaner industries by the private sector will inevitably trigger significant re-evaluation of carbon-intensive assets or simply make them impossible to operate.  Policymakers talk of the ‘climate Minsky moment’ where asset prices can experience sudden and major collapse in value with earthshaking consequences for the wider economy.  An orderly transition towards the low carbon economy is therefore necessary to minimise financial risks; the world, however, is quickly running out of time to ensure it is a smooth evolution, rather than a ruinous revolution.  As the Bank of England’s former Governor Mark Carney cautioned: ‘Companies that don’t adapt – including companies in the financial system – will go bankrupt without question’ .

A Fundamental Reshaping Of Finance

Boardrooms around the world have certainly become more cognizant of the threat posed by the global warming.  For the first time in its history, Global Risks Perception Survey published by the World Economic Forum in 2020 found all top five long-term risks in terms of likelihood taken by the climate-related issues .  In his widely anticipated annual letter to the CEOs, Larry Fink, Chairman of the world’s largest asset manager BlackRock, echoed this view by warning companies that ‘climate risk is an investment risk’ and adding that the world is ‘on the edge of a fundamental reshaping of finance’ .

A long and challenging journey of adjustment awaits the industry, however, especially as it starts from the position of the world’s major facilitator of carbon-intensive assets and operations.  Suffice to look at the asset managers’ past investment priorities since BlackRock’s recent transformation into a cheerleader of climate change action conceals a rather nuanced picture.  According to an investigation by The Guardian, the world’s three largest asset managers – BlackRock, Vanguard and State Street – have around US$300 billion in fossil fuel investment portfolios and their holdings have actually increased since the Paris Agreement.  Furthermore, both BlackRock and Vanguard have gone on record for opposing shareholder motions aimed at encouraging management to do more on climate change .  Activists are right to sound the alarm that the industry still has a long way to go to fulfil its grand rhetoric.

Whilst a complex and challenging task, transition to the net zero emissions world offers exciting opportunities for companies that manage to embrace new thinking as well as harness new technologies.  The Banking Environment Initiative (BEI), which brings together chief executives of some of the world’s largest banks, explored the mechanisms for accelerating finance of the low carbon economy and – through this – sought to develop a vision for a bank of 2030.  The research found that the industry largely applies a short-term approach to climate change and often within the corporate social responsibility constraints only.  Similarly, when the UK’s Prudential Regulation Authority (PRA) reviewed the industry practices, it found that whilst firms have been enhancing their risk management capabilities, most of them still lack a strategic approach to the impending challenge . 

BEI concludes that banks need to develop an ‘active mindset’ which drives sustainability agenda rather than adopts a passive approach and misses an opportunity to influence clients’ investment practices .  Banks that facilitate their clients’ successful transition to the low carbon economy through close relationship of trust will secure their own long-term survival.  To that end, they need to develop a long-term strategic vision fit for an alternative future as well as empower their employees to spur innovation and cross-organisational collaboration.  This will help banking institutions to evolve into an intermediary of sorts which provides not just capital to its clients but also counsel and support by linking them to expert counterparties that help realise the low carbon ambition. 

So far, however, banks have mostly failed to adequately recognise climate-related risks largely because corporate planning horizon does not stretch long enough to incorporate the global warming’s severe long-term impact.  Furthermore, history is a poor guide to the future, which means companies are planning for the unknown.  Scientists warn of an extraordinary shift in the operating environment in the decades to come, something that the current generation finds difficult to perceive.  Policymakers, however, are warning of a ‘too little, too late’ approach when political and business commitment to tackle climate emergency is too delayed to make any difference.  

Regulating For Better Weather

A key enabler for a smooth transition towards a low carbon world could be a consistent classification of activities to enable firms to identify, and invest in, environmentally sustainable assets and projects.  To this end, the European Union adopted a so-called Taxonomy Regulation earlier this year which creates a mechanism for determining whether an activity supports the sustainability agenda.  Work is still in progress on technical criteria, such as how to determine if the activity contributes to climate change mitigation or transition to circular economy, with the detailed framework expected by 2022. Policymakers hope this will accelerate investments in green projects as well as minimise instances of ‘greenwashing’, where firms assert they undertake sustainable activities with no apparent evidence to support their claim.

Timely transition towards low carbon activities also relies on meaningful disclosure that can help investors make informed decisions.  In the absence of a consistent approach to reporting obligations, however, investors find it difficult to get hold of complete, reliable and comparable information.  As DWS, an asset management firm, pointed out, there are hardly any annual reports which provide granular enough data, such as location of every warehouse or detailed analysis on exposure to vulnerable geographies .  This may significantly underestimate the investments’ riskiness.

To respond to this need, the Task Force for Climate-related Disclosures (TCFD), established by the Financial Stability Board, has produced recommendations for voluntary reporting of decision-useful climate-related financial risks.  They offer guidance for discussing not just governance arrangements, but also encourage disclosure of metrics and targets for assessing both risks and opportunities.  Although reporting quality continues to fall short, recommendations quickly became a model for policymakers around the world:  The European Union’s guidance on reporting climate-related information developed last year largely builds on them.  The UK’s Financial Conduct Authority is also consulting on requiring commercial firms with a UK premium listing to state if they comply with the TCFD-aligned disclosures noting that the industry still needs time before mandatory disclosure can be introduced .

Indeed, the world has a long way to go to mitigate effects of the global warming.  This requires not just a shift in assets allocation but a mindset transformation of all economic players.  The future of the planet is at stake and financial industry has everything to lose if the world gives up on trying to tackle the climate emergency.  The good news is that the objectives are clear and the industry is already taking tentative steps towards a better and more sustainable future.