Last week, an opinion article in the Washington Post by Robert Samuelson somewhat skeptically noted that recent announcements by BlackRock and other financial institutions were not a substitute for strong, unequivocal policy direction to address climate change. Samuelson was correct on one front: There is a desperate need for policy to align with, reinforce, and accelerate a low-carbon, climate-resilient transition.
But we also need the financial sector to step up, and as we noted in a blog earlier this month, BlackRock’s announcement puts a marker down that the pathway for seeking solid investment returns runs through good climate risk screening to minimize climate risks and maximize sustainability. Given BlackRock’s size and influence on the overall financial sector, their self-interest in minimizing value-at-risk from climate impacts in order to seek good, sustainable investments is significant. It’s a good bet that other investors will follow, and in following hopefully we’ll begin to see assessment of climate risks emerge in financial statements, quarterly earnings calls, and investor briefings, not just sustainability reports.
There is, however, an important point to be emphasized as both the financial sector and policymakers step up their action to address climate change: Any efforts to address the financial aspects of climate risk must not lose sight of the need for those efforts to be inclusive, i.e., responsive to and equitable for all segments of society if they are to be truly successful in managing the impacts of climate change.
While it is valuable for everyone to better understand and quantify value at risk from climate impacts in the short, medium and long terms the fact is: Climate change impacts everyone but doesn’t impact everyone equally. The financial consequences of these impacts can be particularly skewed in the context of current income inequality both locally and globally, and often strike hardest at the vulnerability of those whose ability to absorb financial stress brought about by climate impacts is limited.
Recent acute climate-related events have illustrated how the financial stress of climate change will be felt at each level of the economy. Less wealthy communities in places such as Houston, Puerto Rico, and Australia are acutely aware of how climate change can impact local economies, jobs, and livelihoods, including in terms of business interruption, loss of income and economic activity, not to mention the costs of rebuilding. As McKinsey noted recently, the economic and social impacts have the potential to grow, intensify, and multiply for the most vulnerable.
One indicator of how the financial stress of climate change may manifest for the most vulnerable is in the “protection gap”, which is a measure of the differential between insured losses (which are ultimately recouped in part or whole when claims are paid out) and overall economic losses, costs which are borne directly by households, businesses, and communities. In its 2019 catastrophe update, Munich RE noted that while overall global economic losses from climate-related events were slightly lower in 2019 compared to the prior year, the protection gap was larger due in part to the higher proportion of flood-related losses in regions and communities with poorer and uninsured populations. In the United States, Swiss Re estimates the catastrophe risk coverage level is 35%, which itself implies a good deal of uninsured people with their own homes and livelihoods at risk. The situation is far more stark in emerging markets, where catastrophe risk coverage averages at 6%, according to S&P Global. As climate-related loss events grow in frequency and severity, the protection gap is at risk of growing itself. This is unsustainable for everyone, including governments, whose balance sheets might bear the brunt most directly, but also for the financial sector and of course most importantly those vulnerable populations themselves.
A vibrant financial system and resilience to climate change are interconnected and mutually reinforcing, but having both will require policymakers and investors to seriously address the protection gap issue. Both public and private finance have large roles to play of course, including through “blended finance” approaches that involve using public or patient capital to catalyze investments that have a public-good element, often through risk sharing. Blended finance approaches have been employed for decades to address climate issues, including climate-related parametric insurance for emerging markets (such as the recently launched Natural Disaster Fund Deutschland), green and resilience banks and funds, and loan guarantee programs for renewable energy and sustainable infrastructure.
Insurance is also a key component of a vibrant financial system. Insurance doesn’t imply climate risks are reduced (it is a risk-transfer mechanism) but, when coupled with ex-ante investment in resilience, it can be a critical catalyst for climate action. Among its useful functions, insurance serves as an important tool to price risk and signal that risk to the market. Second, as a financial mechanism, insurance plays an important role in helping to reduce financial vulnerability, allowing those who have insurance to access capital post-disaster, enabling them to bounce back faster.
To close the protection gap, policymakers and investors should focus on three things: (i) incentivizing investment in resilience, including in infrastructure and community systems which can reduce vulnerabilities to climate risks, (ii) ensuring there is a clear, transparent price signal of climate risks, and (iii) providing targeted, affordable insurance programs that incentivize resilience and address climate vulnerabilities without creating perverse incentives for inaction and overreliance on government or subsidies.
These things may seem difficult to square, but clear-eyed public-private blended finance approaches focused on managing climate risk can incentivize ex-ante investment in resilience, convey transparent risk pricing, and help those least able to afford insurance gain coverage are possible. One example is the InsuResilience Global Partnership for Climate and Disaster Risk Finance and Insurance Solutions, which was created in 2017 to help hundreds of millions of climate-vulnerable households and businesses find protection from climate risks. InsuResilience complements the hard work of governments, property owners, businesses, and communities to finance climate-smart infrastructure by developing climate-related risk-transfer products to serve customers in neglected markets.
Public and private finance must come together to grow vibrant markets for risk management products that make the financial system inclusive. Good policy coupled with climate risk assessments by the likes of BlackRock can redirect capital and scale up climate-resilient investments, such as in infrastructure, and build markets for insurance that close the protection gap in all economies, including emerging markets. While skeptics may be justified in their belief that both policymakers and investors may have a long way to go, the financial sector has a golden opportunity to ensure that no one is left behind as it begins to play its part in addressing the climate crisis.