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Physical Risk - Risk Management - Transition Risk

Exploring the Connections Between Climate Change and Global Financial Stability

One of the many reasons for caring about climate change is its potential to lead to financial instability. But how might this happen and how likely is it?

Thursday, May 16, 2024

By Jo Paisley

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Note: This article is Part 1 in a series of two articles. It draws upon the Green Templeton Lecture on the topic, delivered by Jo Paisley on February 8, 2024.

When thinking about the financial impacts that climate change might have, it’s become well established to consider both physical and transition risks. Physical risks arise from specific weather-related events, such as more intense rainfall, heatwaves and wildfires, as well as longer-term shifts in climate patterns such as rising sea levels and increasing mean temperatures. Transition risks arise from the adjustment toward a low-carbon economy, including legal and policy impacts, changes in technologies, shifts in consumer and investor sentiment, and changes in the supply and demand for products.

Financial firms, such as banks, insurance companies and asset owners, might be impacted directly by physical risk events (e.g. flooding to branch networks) or transition risks (e.g. emissions regulations). But the main financial impacts will come through the indirect effect on the counterparties they lend to, invest in or underwrite. For example, counterparties which are unable to operate for many months because of severe flooding, might be unable to repay debt, increasing credit risks to banks. Some business models will become unviable in the face of tighter environmental regulation, leading to stranded assets and credit risk losses.

 

How Could Climate Change Undermine Financial Stability?

When considering the potential for impacting financial stability, it’s helpful to look at the scale of how large physical and transition risks might be.

Let’s take physical risks first. Climate change is affecting the entire distribution of weather outcomes, increasing the probability of more extreme weather (or tail risks). So far, there have been very real economic losses associated with physical events. However, this has not yet translated into financial stability concerns. In other words, there have not been bank failures or interventions needed by the authorities because of systemic failures in the financial system.

But how will these risks develop in the future? We know that lags in the climate system mean that historic emissions will cause much of the global warming for the next few decades. The Potsdam Institute for Climate Impact Research led one recent study, which concluded that large income reductions would affect most regions, irrespective of future emissions, but with South Asia and Africa the most affected. Their study estimated global annual damages of USD 38 trillion, coming via the impact of rising temperatures, changes in rainfall, and temperature variability.

It takes decades for there to be a discernible difference in the trends of global warming across the variety of available climate scenarios. Consequently, how emissions evolve over coming decades will have a material impact on how physical risks evolve beyond the next twenty or thirty years. Although there is a lot of uncertainty around the Potsdam study estimates, it’s clear that the damages will become even larger beyond 2050 if emissions are not cut significantly. And whether this will trigger financial instability will depend on how and where the losses occur. Do the impacts manifest as a steady decline in average growth and productivity? Or are there a series of catastrophic events that impact the financial system?

The size of transition risks is less clear and depends on factors such as the ambition and scope of policy, the pace of innovation, how consumers and investors react, and how supply and demand for goods and services evolves. These transition risk factors are not only path-dependent, but also likely to be influenced by the physical risks that we experience. Severe physical events, for example, might lead to pressure for more ambitious policies to tackle climate change, hence potentially increasing transition risks. Conversely, ambitious climate policies can face political backlash and be watered down (as discussed in a 2022 podcast) – which is a case of transition risks being lowered, but at the expense of potentially higher future physical risks.

One obvious threat to financial stability through transition risks is the potential for stranded assets. Limiting global warming to well below 2oC means that a large proportion of existing fossil fuel reserves will need to stay unused. A study in the journal Nature estimated that 60% of oil and gas reserves and 90% of known coal reserves should remain in the ground if we are to limit global warming to 1.5°C. This will have knock-on consequences for the value of companies involved in fossil fuel production, as well as the related infrastructure (e.g. pipelines). The risk of stranded assets may not be fully priced into these assets given uncertainty over the timing of any restrictions or even the political will to enact the requisite policies. However, whether this is sufficient to create financial instability remains a live debate. The quicker and more abrupt the (expected) transition, the higher the chance of an impact on financial stability.

But three more factors are also relevant for assessing climate-related financial stability risks, namely compound and cascading risks and tipping points. Compound risks occur where a combination of hazards or risk drivers occur and increase the overall severity of particular events (e.g. extreme heat intensifying wildfires or sea-level rise and high precipitation increasing the scale of flooding and storm surges). Cascading risks occur when one hazard triggers another hazard in a series. The European Environment Agency recently published its first European climate risk assessment in which it noted these types of impacts, offering a scenario where mega-droughts lead to water and food insecurity, disruptions to critical infrastructure, and threats to financial markets and stability. The World Economic Forum’s annual Global Risk Reports have similarly highlighted these sorts of cascading impacts for many years (Figure 1). Thus, even if an event isn’t labelled as a ‘climate risk’ (bottom row), it can have been made more likely or more severe by the presence of climate change.

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 Source: WEF The Global Risks Report 2022

 

Tipping points are where a small change becomes significant enough to cause larger, more critical changes that can be abrupt, irreversible and lead to cascading effects (Figure 2).

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Source: Global Tipping Points Report 2023

 

Recent research suggests that a series of such tipping points become far likely beyond 1.5℃ warming. These include Greenland and West Antarctic ice sheet collapse, warm-water coral reef die-offs, overturning circulation collapse in the North Atlantic Subpolar Gyre and widespread permafrost thaw. The Greenland ice sheet, for example, contains enough water to raise global sea levels by around 7 meters, albeit over a much longer timescale than is generally considered relevant for financial stability.

There are also social and technological tipping points, which can be helpful. Studies of past innovations indicate that change can be exponential once certain thresholds in adaption have been passed. Although these types of changes could be very beneficial from a climate mitigation perspective, such rapid structural economic changes would also entail heightened transition risks (e.g. as some business models become obsolete).

 

Assessing Potential Risks to Financial Stability

With the risk landscape evolving in complex and poorly understood ways, it’s not surprising that financial regulators have become increasingly concerned about the impacts on the financial system. Of particular importance for financial firms is the creation of the Network for Greening the Financial System (NGFS). This ‘coalition of the willing’, comprising supervisors and central banks from around the world, exchange experiences, share best practices and contribute to the development of environmental and climate risk management in the financial sector. By the end of 2023, there were 134 members and 21 observers, up from the original eight members at its inception in 2017.

These supervisors are increasingly using scenario analysis as a tool to size the likely financial impacts from climate change and assess the likelihood of impacts on financial stability. The NGFS has also been instrumental in developing climate scenarios for use in supervisory exercises. In November 2022, the Financial Stability Board (FSB) noted that there had been 35 climate scenario analysis exercises completed, with a further 19 in progress and 12 being planned. According to GARP’s research, NGFS and regulatory scenarios now increasingly dominate the financial system (Figure 3).

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Source: Climate Financial Risk Forum Guide 2022: Scenario Analysis in Financial Firms

 

The benefits of this include a greater ability to compare results across exercises, although in practice that is difficult due to differences in methodology, timescales employed and tweaks made to the scenarios for the supervisor’s home jurisdiction.

But, what do these climate scenario analysis exercises tell us? Although they vary considerably, none indicate impacts that are large enough to threaten financial stability. For example, the European Central Bank found that under a short-term three-year Disorderly Transition risk scenario and two separate physical risk scenarios, credit and market risk losses for the 41 banks in the exercise were around 70 billion Euros. The Federal Reserve Board’s pilot climate scenario analysis exercise was useful in providing insights into the range of practices across the six participating bank holding companies. Estimates of impacts varied widely, but were not in the realm of triggering financial instability.

So, can we relax about financial stability? Certainly not, in part because the adequacy of these scenarios is being increasingly questioned. For example, a recent report noted how hot-house scenarios underplay the risks because they exclude many real-world impacts, such as tipping points, sea-level rise and involuntary mass migration. They also point out that the choice of damage function and economic model drives very material differences in the results. For example, some models show the hot-house world to be economically positive, whereas others estimate a 65% GDP loss or a 50–60% downside to existing financial assets, if climate change is not mitigated.

Supervisors too have reported that they feel that the risks are understated, including the lack of second-round effects, non-linearities and the potential for abrupt corrections in asset prices from transition shocks (e.g. triggering fire sales of exposed assets).

A recent article in the journal Nature urges greater multi-disciplinary collaboration to understand a range of missing risks – that is, risks that are not included in economic evaluations because of their uncertainty, perhaps reflecting our lack of understanding or simply because they are not captured in existing economic models. This includes issues such as the social impacts of climate change (e.g. social conflict, dislocation).

 

Parting Thoughts

Climate change is leading to physical and transition risks and could be exacerbated by compounding and cascading risks, and tipping points. Physical risks will continue to rise over coming decades, but the scale of financial risks that these will pose are highly uncertain. Transition risks will depend on factors such as policies enacted, the speed of innovation and consumer/investor sentiment. While they will continue to cause economic losses, together, will these risks be large enough to create financial instability? It would take a brave person to rule it out. But we should also consider the possibility that the transition is not going as fast as it should because of concerns that a faster transition (e.g. through more extreme policy choices) itself could cause financial instability. In part 2 of this article we will explore the ways that the financial system impacts climate change.

Jo Paisley, President, GARP Risk Institute (GRI), has worked on a variety of risk areas at GRI, including stress testing, operational resilience, model risk management, and climate and environmental risk. Her career prior to joining GARP spanned public and private sectors, including working as the Director of the Supervisory Risk Specialist Division within the Prudential Regulation Authority and as Global Head of Stress Testing at HSBC.




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