Climate Change and Financial Stability: Which Risk Is Most Critical?

Which risk posed by climate change to financial stability is the most critical for investors?

It’s a complex but pertinent question, especially in the wake of the COP21 deal reached in Paris by almost 200 nations. Before we attempt to answer it, let’s first achieve some clarity on the meaning of financial stability and the risks climate change poses to it.

What Is Financial Stability?

Financial stability is a favorite term of central banks. So how do they define it?

According to the European Central Bank (ECB), “Financial stability can be defined as a condition in which the financial system — intermediaries, markets and market infrastructures — can withstand shocks without major disruption in financial intermediation and in the effective allocation of savings to productive investment.”

The Bundesbank defines financial stability as “the financial system’s ability to perform its key macroeconomic functions, and particularly so in periods of stress and upheaval.”

The Bank of Japan (BOJ) says that financial stability “refers to a state in which the financial system functions properly, and participants, such as firms and individuals, have confidence in the system.”

While the central banks each put it differently, the various definitions are consistent with an intuitive understanding: You have financial stability when financial systems can, by and large, continue to function despite shocks.

How Does Climate Change Threaten Financial Stability?

Mark Carney, the governor of the Bank of England, explained how he thinks climate change could affect financial stability in “Breaking the Tragedy of the Horizon — Climate Change and Financial Stability,” a speech he gave at Lloyd’s of London in September 2015:

“There are three broad channels through which climate change can affect financial stability:

• “First, physical risks: the impacts today on insurance liabilities and the value of financial assets that arise from climate- and weather-related events, such as floods and storms that damage property or disrupt trade;
• “Second, liability risks: the impacts that could arise tomorrow if parties who have suffered loss or damage from the effects of climate change seek compensation from those they hold responsible. Such claims could come decades in the future, but have the potential to hit carbon extractors and emitters — and, if they have liability cover, their insurers — the hardest;
• “Finally, transition risks: the financial risks which could result from the process of adjustment towards a lower-carbon economy. Changes in policy, technology and physical risks could prompt a reassessment of the value of a large range of assets as costs and opportunities become apparent.”

This gives us a good idea of how a central banker may view climate change risks and financial stability. But investors are going to be more worried about which of these three risks will affect them the most.

Poll: Transition Risk Tied with Physical Risk

We asked readers of CFA Institute Financial NewsBrief which type of risk is most critical for investors to consider. Among our 322 respondents, transition risk and physical risk each received 40%. In what may be disappointing news to those in the legal profession, liability risk came in a distant third (20%).

Regarding climate change and its potential impact on financial stability, which of the three risks identified by the governor of the Bank of England is the most critical for investors?

It is interesting that while climate change is strongly associated with the physical risks of floods and storms, transition risks are perceived as equally worrisome. What would explain that? The answer likely lies in the fact that financial markets operate based on the expectations of changes to come. And long-term investors need to take into account long-term trends, such as the transition to a low-carbon economy — a shift that may have more wide-ranging effects than climate change-induced natural disasters in the years ahead.

Many are expecting some sectors, such as coal energy, to suffer because of the growing pressure to reduce carbon emissions. At the same time, much is being written about companies that appear to be leading the transition. In an interview with CFA Institute, David Blood, co-founder of Generation Investment Management and former CEO of Goldman Sachs asset management, said that “for long-term investors, when they debate hold or divest coal or tar sands assets, the answer will be divest. It’s a no-brainer.” It is also a testament to the influence of transition risks that terms like “stranded assets” are finding their way into investment vocabulary.

Much can be said about the transition to a low carbon economy, but in short, it is a part of the broader move towards sustainability. In investing that means the integration of environmental, social, and governance (ESG) issues into traditional investment analysis and decision-making processes.

Final Word

No word resonates more with investment professionals than “risk,” and climate change is becoming the risk of the 21st century. As the threats posed to financial markets by climate change are understood with greater clarity, some investors seem to be taking note.

And if this survey is any indication, transition risk – as well as physical risk — should be at the front of their minds when they look at their portfolios.

If you would like to know more about how climate change relates to investing, considering reading “Climate Change and Investment Decisions: Selected Reading.” You may also be interested in Environmental Social & Governance Issues in Investments: A Guide for Investment Professionals, which was published by CFA Institute to offer a comprehensive introduction to ESG considerations in investing.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.