Science has given the Financial Sector a Clear Horizon to Act on Climate Change

2018-12-12T16:05:01+00:00October 13th, 2018|Climate Risk, Greening Finance|

From a financial perspective, the latest Intergovernmental Panel on Climate Change (IPCC) report, issued on Monday by the UN, should raise alarm bells.  The IPCC report – which reflects the consensus of ninety-one scientists from 40 countries and drawn from more than 6,000 studies – has very clearly laid out our collective time horizon:  we may have as little as 12 years before we are fully locked in to the impacts of at least 1.5°C warming, which could be reached as early as 2040 and appears increasingly certain to bring devastating consequences.  Under these circumstances, the range of damages to be expected include more than 400 million additional people exposed to severe droughts, and more than 570 low-lying coastal cities with more than 800 million people will be at risk of sea level rise and inundation. Development and eradication of poverty will be set back around the globe, with many countries losing several percent or more of GDP.  Much worse consequences will result if global warming is allowed to reach 2°C or more – as is currently expected barring any major interventions to reduce greenhouse gas emissions.

Why does this matter from a financial perspective?  The impacts from climate change will not only affect living standards worldwide, but also have the potential to accelerate the widespread devaluation of investments, assets and personal wealth, and to disrupt the financial sector as a whole. Events such as the Thailand floods of 2011, which resulted in a 1.6% reduction in annual GDP, will be increasingly frequent. Increasing levels of physical damage, interruption of business, and devaluation of assets due to the impacts of climate change will affect individuals’ income, reduce businesses’ revenues, increase financing and operating costs, and hurt investors’ returns. In the long term, the IPCC report estimated that the global economic damages caused by climate change will reach $54 trillion in 2100 under warming of 1.5 degrees Celsius.

With 1.5°C warming likely within a 22-year time horizon, the potential for financial impacts from physical climate impacts is not merely theoretical – it is within sight.  If you are in the market to invest in a new home, this horizon is shorter than a 30-year mortgage.  If you are an infrastructure investor, this horizon is a fraction of the useful life of most major infrastructure investments, such as roads, bridges or ports.  If you are a pension fund, this horizon is significantly shorter than your long-term obligations to fully fund pensioners currently paying into your system.  Poorer communities across the United States and in many developing countries, which are already vulnerable and where income inequality is stark, will suffer even more.

The IPCC report highlights the need to align financing (and the financial system) with the reality of the science, noting explicitly some of the required shifts in how we invest, allocate capital and use the financial system to ensure our resilience.. Some recommendations to incentivize all forms of capital to flow in the right directions include:

  • Changing incentives for private day-to-day expenditures, and redirecting savings towards long-term productive low-emission assets and services;
  • Mainstreaming climate finance within financial and banking system regulation;
  • Allowing developing countries (and perhaps all vulnerable communities) to access low-risk and low-interest finance for climate-smart investments through multilateral and national development banks; and
  • Creating new forms of public-private partnerships with multilateral, sovereign and sub-sovereign guarantees to help de-risk, catalyze and accelerate climate-friendly investments.

This realignment of the financial system was precisely what Mark Carney, the governor of the Bank of England, underscored in 2015 when he said that climate change represents the ‘tragedy of the horizon.’  Carney argued that the “short-termism” of many investors leads to the neglect of climate change in today’s investment decision-making – across all sectors, asset classes, investor types, and indeed among financial policymakers – all but ensuring that it will be too late to for financial regulators to play their part to address climate change once it becomes a critical issue for financial stability.

The good news is that there is more than twenty years of research, economic analysis and practical – indeed actionable – ways to address financial resilience to the impacts of climate change.  The same week the IPCC report came out, this year’s Nobel prize in economics was awarded to Yale economist William D. Nordhaus for his modeling on the benefits of reducing global warming and the efficacy of carbon taxes. Development finance institutions have been working on accelerating and scaling up climate-smart investments for more than 20 years as a matter of their sustainable development mandates and analysis from the Global Commission on the Economy, and Climate shows that bold climate action could deliver $26 trillion in economic benefits worldwide by 2030.

From a practical perspective, much is being done to help stakeholders within the financial system understand climate risk better, including giving them as much information about climate risk as possible.  For example, the Task Force on Climate-Related Financial Disclosures (TCFD) established by the Financial Stability Board has produced a framework for voluntary climate-related risk disclosure, addressing the information asymmetry challenges facing investors who want to know the climate risk of prospective investments.  This framework has received support from more than 500 companies, governments, and industry associations.  Pension funds are also getting interested in understanding their climate risk.  And infrastructure investors – including importantly the development banks that help finance infrastructure in emerging markets – are turning their attention to integrating climate resilience into the design of new infrastructure projects. On our part, CFA has worked with other colleagues to produce a Lenders’ Guide for Considering Climate Risk in Infrastructure Investments, which is targeted towards helping infrastructure banks understand the linkages between climate risk and a project’s revenues, assets and costs as they appraise new investment.

And there are tremendous opportunities for investing in resilience. The global green bond market has grown exponentially with 2017 global issuances reaching an all-time high of $173 billion. Loans specifically marketed for “green” projects are also emerging: in Latin America, BBVA has provided the first green corporate loan in Latin America with Iberdrola and the first in the U.S. with Avangrid and is working with a consortium of other banks to develop the Green Loan Principles. Private equity players like the Lightsmith Group led by Jay Koh are also looking at the opportunities to invest in resilience, by investing in companies that with products and services for adapting to a changing climate such as supply chain analytics, weather modeling, precision agriculture, water efficiency, distributed energy, business continuity, disaster response, infrastructure engineering, and parametric insurance.

Notwithstanding the significant opportunities and strides we have made thus far, the recent IPCC report is a wake-up call, with very tangible impacts within sight of the most short-sighted among us.  As investors get a clearer vision of climate change, smart investors will take a serious look at the implications this report will have on their investments and will start to act.