Deloitte-uk-climate-change-and-the-threat-to-financial-stability

Last month the governor of the Bank of England, Mark Carney, issued a stark warning about the impact of climate change: “If…companies and industries fail to adjust to this new world, they will fail to exist”. Mr Carney’s statement was co-signed by the chair of the Network for Greening the Financial System, a coalition of 36 central banks, including the People’s Bank of China. The Network helps central banks measure and mitigate the risks to the financial sector posed by climate change. Last month’s statement signals that climate change has well and truly arrived as an issue for central bankers.

Maintaining financial stability is a core task of central banks. They have long monitored levels of borrowing and asset prices or signs of incipient trouble. Economies can also be knocked off-balance by so-called exogenous, or external shocks, such as Brexit or trade tensions. Central banks watch closely for these kind of risks, too.

Climate change is a quite different category, but one that now commands the attention of central bankers. The Bank of England has identified three channels through which climate change threatens financial stability.

First, through the damage to property, trade and infrastructure from more frequent and severe weather. The losses, insured and uninsured, and the impact on future insurance premiums, are potentially enormous. A recent report by Swiss Re found that natural disasters in 2017 and 2018 alone cost $219 billion, a record for a two-year period. Rising temperatures are likely to mean still-higher losses, a sobering thought given that the UN thinks global temperatures are on track to rise by 3-5 degrees centigrade by the end of this century. Another insurer, AXA, warns that the industry may simply be unable to cope with the scale of the risks. It says that if temperatures were to rise by more than four degrees centigrade by the end of this century the world would become “uninsurable”.

The second channel is so-called transition risk, where an abrupt and disruptive shift to a low carbon economy hits the financial system and the economy. In such a situation energy costs would soar, swathes of the capital stock would be rendered obsolete and the market value of carbon-intensive industries such as oil, autos and transport, would drop. The end of a long era of cheap oil in the early 1970s provides an unsettled precedent. The oil price rose more than three-fold between 1973-75, contributing to severe recessions, soaring inflation and political dislocation in much of the developed world.

The third channel identified by the Bank is through businesses facing demands for compensation. Individuals or groups who suffer as a result of climate-related events may seek to claim against companies they deem responsible. Investors in a business that suffer losses as a result of undisclosed vulnerability to extreme weather might also seek damages from the company.

The US has a long history of consumers and others seeking damages against businesses, perhaps most spectacularly the $200 million settlement against four US tobacco companies in 1998. Earlier this year Californian utility PG&E filed for bankruptcy in what the Wall Street Journal dubbed “the first climate-change bankruptcy, probably not the last”. The company faced huge potential liabilities resulting from wildfires that swept the state in 2017 and 2018. Victims of the fire claim PG&E’s equipment and maintenance work failed to deal with the growing threat by dry weather.

It is not just central banks that are worried about climate change. Many commercial banks are examining their direct exposure to climate change-related risks. Last year the Bank of England reported that most UK lenders were starting to assess whether climate change could, for instance, affect the value of their mortgage assets or holdings of government bonds (flooding could hit the value of a mortgage book while a government affected by extreme weather could see the value of its debt decline).

Regulators say much more needs to be done. The European Systemic Risk Board advocates ‘carbon stress tests’ to assess the impact on banks’ capital and profitability of a sudden and chaotic shift to a low-carbon economy. This could leave companies nursing huge losses and an unviable business model, leaving the banks that lent to them with enormous unpaid debts.

Last month the UK’s Prudential Regulation Authority published a statement on climate risk for banks and insurers. The statement requires boards to assess and take steps to deal with financial risks from climate change.

Last week the UK’s Committee on Climate Change recommended setting a 2050 target to end net emissions, something to which no other big economy is committed. The committee forecasts that to do so will cost 1–2% of GDP a year by 2050.

Progress is being made. UK carbon emissions are 43% lower than in 1990, despite the fact that over this time GDP has grown by 75% and the population by 17%.

The question is whether a gradual adjustment, one that avoids major economic disruption, will prove enough. Fossil fuels are the ubiquitous, general purpose technology of the modern economy. Weaning the world off them is an epic task. Mark Carney has warned of what he calls the “tragedy of the horizon” – the risk that, by the time there is a consensus for arresting climate change, it may be too late.