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The Financial Stability Board (FSB) has warned in a new report that financial markets could be disrupted by climate change and associated catastrophes in a number of ways. From costs rising slowly but significantly over time to sudden unexpected shocks having huge ripple effects, climate change is going to be pushing costs up bringing financial troubles — the questions are how much and how soon.
“The world’s financial stability watchdog has warned that disasters caused by climate change are increasingly likely to trigger broader panic in financial markets,” the Financial Times (FT) writes. “The Financial Stability Board said the financial damage of climate shocks such as floods, droughts, fires or storms could cause a broader pullback in lending and downturn in investor confidence.”
Additionally, insurance is getting more expensive and harder to get in places where climate disasters hit hardest.
“There is a growing focus on potential risks to financial stability from climate change. Climate-related events are becoming more common, which raises concerns over institutions’ ability to manage their risks and to continue to provide financial services in certain segments and geographies,” FSB writes.
“Climate-related vulnerabilities in the financial system, when triggered by climate shocks, could threaten financial stability through various transmission channels and amplification mechanisms. Analysing climate-related vulnerabilities consists of tracing through how climate shocks trigger the traditional vulnerabilities laid out in the FSB’s financial stability surveillance framework. This can be more complicated than for non-climate shocks given uncertainties around their timing and magnitude, non-linearities from tipping points, as well as second-order and spillover effects. The FSB’s work focuses on assessing climate-related vulnerabilities in the global financial system, particularly from a cross-border and cross-sectoral perspective. It forms part of the FSB’s 2021 Roadmap to coordinate work across standard-setting and other international bodies to address the financial risks of climate change.”
The report gets very detailed and uses plenty of jargon. It really goes into nuance, too. Financial markets aren’t perfect as is. As we’ve seen from a number of financial crises, systemic mistakes and holes leave vulnerabilities that can collapse the system. Throw in a whirlwind of climate events and any vulnerabilities in the financial system can lead to disaster. “Climate shocks can interact with existing financial vulnerabilities in the real economy or the financial system and lead to financial losses. Climate shocks could materialise through abrupt changes in policies, technological innovation or consumer preferences (transition risks), or through the materialisation of physical hazards, such as floods, droughts or windstorms (physical risks). The interactions of transition and physical risks or among physical risks could be a particular source for non-linear climate dynamics and compound climate shocks could be further amplified by existing financial vulnerabilities, such as asset mispricing or high leverage, creating financial losses,” the report adds. It also talks about potential amplification and feedback effects.
“To reach a system-wide view, the framework considers a broad range of cross-sectoral and cross-border channels that may affect the financial system via real assets and financial markets, and distinguishes between the effects of climate shocks, their transmission and amplification. Once crystalised, climate-related risks are transmitted and amplified through the traditional channels used in financial stability assessments, including credit, market, and liquidity risks. Climate shocks could also affect the real economy through damage to real assets or the creation of stranded assets, or a disruption to economic activity that can feed back to the financial system.”
When considering shocks to the system, one has to bring in expectations. The more that is expected and priced in, the less shock there is. The less that is expected and the more extreme the events, the more likely shock presents itself. “The ultimate effect of such channels on the financial system depends upon the magnitude of climate shocks, the extent to which they are anticipated and thus priced into asset values, where the associated financial risks materialise, and how they are managed,” FSB writes. “Risks that are opaque and not well-managed could create correlated shocks whose impact is magnified as they propagate through the system.”
The more you read, the more concerning it all sounds.
The report zeroes in on the real estate market and how insurance matters could create growing problems. “The analysis involves a severe yet plausible conceptual scenario of how a climate physical shock to the real estate sector may affect financial stability if insurance becomes less available, which causes risks to shift to households and businesses or to governments. It also identifies the different channels through which risks could spread across the financial system and relevant metrics to monitor such channels.”
Dive into the report for much more detail. It’s worth a read.
Overall, it’s clear that financial markets could face increasing strain, and even collapse, as climate-related disasters strike bigger and bigger. We’ve seen growing financial costs from hurricanes in Florida, Georgia, and North Carolina in recent years, and we’ve seen a whole other level of shocking financial pain from wildfires in California. These things aren’t going away. The question is how much bigger they’ll get, how well financial systems and markets will be prepared for them, and how people and businesses will respond in managing their money and their property.
I’d say that things are already getting concerning, with insurance companies just leaving high-risk areas, and what that might lead to when disasters hit, or hit a couple of times. “The Californian crisis has put the spotlight on how some major companies have been pulling out of the state, leaving about 10 per cent of residences without home insurance and many others reliant on a non-profit insurer of last resort.” Another big fire or three and what does that lead to? Just think about how this will all add up to macroeconomic challenges. The recent California fires could cost insurers $30 billion in payouts, according to Wells Fargo. $30 billion. No wonder they are abandoning more and more properties. And then consider something similar for flooding and hurricane damage in Florida. And there are 48 other states.
“The industry is looking at an entirely new and unpredictable risk profile for homeowners’ insurance . . . driven by climate factors that are worsening,” Senator Sheldon Whitehouse says. “This isn’t a fiscal blip of some kind that you recover from.”
Featured image: “California Wildfires” by Justobreathe, CC BY 2.0 license.
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