By Preslav Raykov
Global economies face multiple threats, ranging from inflation and ubiquitously rising energy prices to armed conflict and natural disasters. While the accurate prediction of the path of future events is impossible, there is one trend that we can confidently identify as high-risk, and we should be extremely prepared to meet it.
If at the beginning of 2019 someone had warned us about the risk of a global health pandemic and the subsequent shutdown of entire sectors of the economy, and even entire countries, we would have been extremely suspicious and would highly disregard such warnings. It seemed unlikely and insignificant enough for us to give it excessive attention and prepare accordingly.
The same is true for the ongoing war in Ukraine, which continues to take thousands of lives and cause severe economic damage across Europe and the world, as well as to compromise the supply chains of essential energy commodities that we took for granted. It is the full materialization of these two events in such a short period of time that will invariably lead to a change in our perceptions of risk in the coming years. And the models for assessing potential future risks will undergo a significant change in the parameters and magnitudes of the expected forecasts.
The world shall make a concerted effort in order to prepare more actively for the potential new dimensions of risk events of our time, and the decisions and actions to prepare for them will be dictated by the bitter experience of the world economy of the last 3 years. One of these risks on the horizon, which a large part of the population still ignores, is the climate risk to our economies and the global financial system. Taking lessons from recent risky events, global institutions and leaders must adapt our financial systems to potential shocks from climate change.
Climate warnings for the economy and the financial world Catastrophic floods, droughts, wildfires and storms are becoming more and more frequent and regular occurrences these days. According to current projections, social, environmental and economic consequences of climate change could increase to catastrophic levels in the next 50 years.
One of the assessment suggests that if temperatures rise to 4°C above pre-industrial levels over the next 80 years, global economic losses could reach $23 trillion annually. For comparison, the world economy is currently estimated at approximately $100 trillion annually. When it comes to the devastating impacts of climate change, most people think only of the direct damage to life and livelihoods in certain regions. And while they are indeed significant, the effects of increasingly frequent and extreme weather events are just as impactful on the health of global financial systems, which will invariably affect our lives in many ways.
In recent years, the physical impacts of climate-related shocks—such as hurricane damage on power grids, urban flooding, and negative effects on agricultural systems—have been shown to affect directly global financial institutions and the way they make investment decisions, construct their portfolios and create new financial instruments. Climate change is a process that can hardly be controlled or modified in the short term, and much of its change is the result of natural cycles. It must be clear that not all aspects of climate change are caused by human activities, and this must be clearly recognized by global leaders in order to address the truly pressing issues. And also not to additionally burden the economic systems with restrictive policies in sectors that we can hardly prove that they work.
There is no doubt that the risks posed by climate factors will be substantial in the coming decades, and the global economy must be prepared for them. According to a number of reports, climate change could put about 2% of global financial assets at risk by 2100, and in a worst-case scenario, the value could rise to 10%! Such is the scale of the financial devastation that we must be prepared for by providing the necessary financial and economic tools to manage these risks.
Nowadays, there is increasing evidence that catastrophic weather events are occurring more frequently due to climate change. Extreme weather events in many regions of the world are breaking all kinds of records. The fact is that taxpayers and consumers most often bear the costs of these disasters, and they are mounting rapidly. For example, climate disasters that hit the US in 2020 caused $20 billion in damage, and since 1980, extreme weather events have caused over $2 trillion in devastation.
These costs show that climate change is an economic issue and core to risk management in global financial systems. The public finances of a number of countries are already under the enormous pressure of mounting debts and increasingly expensive financing. Private capitals and the investment sector must promptly mobilize resources in instruments to secure potential negative developments caused by climate change. More and more investment funds and private capitals are trying to offer adequate tools to protect against such events, but in the end, taxpayers through the state bear most of the costs.
In 2023, whether you live inland or on the coast, in a small or large city, almost every community, government, company and individual will be exposed to some level of risk from climate change. That is why it is important to take specific economic and political decisions in a timely manner. Families in flood-prone areas will begin to see the cost of their property insurance potentially rise, and a number of companies operating in sectors directly affected by adverse climate change will have to factor these risks into their asset values. Accordingly, insurers operating in these segments will also rethink their models and introduce additional requirements.
Over the past 5 years, we have seen enormous pressure from investors and regulators for companies to disclose their exposure to climate risks. In order to make well-informed decisions about their future operations, banks, insurers and other participants in the financial sector need adequate tools to manage climate risks in their operations and balance sheets. At the same time, as financial supervisors monitor the resilience of the system, they need tools to adequately assess and oversee these risks. Over the past 3 years, several of the main central banks have conducted climate stress tests of the banks' assets and exposure, and the results clearly showed the dependence of a large part of the assets on negative climate changes, and corresponding action was not taken precisely because of the lack of adequately structured instruments.
Although the insurance sector is one of the main victims of the materialization of climate risks, it is still difficult to say that the sector has reoriented itself not to invest in sectors and companies that come under pressure from investors and the public, and are declared as "polluting". For reference: As of the end of 2021, the US insurance industry had invested a total of $582 billion in a combination of companies in the oil, gas, coal, utilities and other fossil fuel industries – a slight increase from the $519 billion recorded in 2018 according to a study by S&P Global Sustainable. This fact clearly shows that the solution to the case lies in the financial engineering of new investment and insurance products, and not in the withdrawal of capital from the respective sectors.
On the other side of the ocean, a 2021 European Central Bank report indicated that climate risks have the potential to seriously affect much of the financial market prices in advanced economies. In Europe, the climate premium is not yet fully incorporated into the prices of a number of financial instruments, and carbon emissions and derivative markets for hedging such risks are still in their infancy. Although the exposure of the European banking and insurance system is relatively limited to the sectors that are mainly affected by climate risks, it is necessary to rapidly apply the climate risk assessment framework to European markets as well. We see such rates of change in the private markets, where the issuance of so-called "green bonds" reached over $1 trillion worldwide.
The new risks are already here, and with them we must also start the processes of active preparation. Climate change is increasingly likely to generate significant risk events in the coming years that could be devastating on the scale of the global Covid pandemic, wreaking havoc on our economies. The financial sector must actively implement adequate market solutions to prepare our economies for these risks.
THE BOTTOM LINE The risks posed by climate factors will be substantial in the coming decades, and the global economy must be prepared for them.
