Falling asset prices due to climate change could undermine global financial stability

Climate change

Financial stability across the world could be under threat from climate change, with the Financial Stability Board (FSB) warning that environmental deterioration could hit asset prices, financial liquidity, and borrower creditworthiness.

The FSB examined the implications of climate change on financial stability in a recent report, concluding that the risk of reductions in the value of financial assets could create losses for banks, asset owners, and other financial institutions.

“The manifestation of physical risks – particularly that prompted by a self-reinforcing acceleration in climate change and its economic effects – could lead to a sharp fall in asset prices and increase in uncertainty. This could have a destabilising effect on the financial system, including in the relatively short term,” says the FSB.

The report cites an estimate that asset prices will fall between 2.9 per cent and 9.7 per cent, adding up to a total cost of between USD4-14 trillion by 2015. This is under the FSB’s baseline scenario, in which no additional action is taken to reduce emissions and the expected global temperature increase is around 4ºC over the period. 

The FSB also notes that the hit to asset prices will depend on the discount rate. If discount rates are low, this could result in a worst-case scenario 30 per cent fall in asset prices, amounting to USD43 trillion.

Furthermore, reductions in the values of assets that are used as collateral may create credit risk, which could affect the financial system by reducing the value of investments and increasing risks to lenders.

The FSB notes that financial stability could fare better under a well-managed transition to a low-carbon economy. “Were such reductions in prices to occur gradually, then they might be less likely to have material implications for financial stability. Similarly, central estimates of some financial institutions’ exposures to the most climate-sensitive sectors appear, in aggregate, fairly contained.”

The FSB notes that there is “already evidence that the market value of equities of firms in some heavily polluting industries is being impacted by policy measures and market trends related to a transition to a low-carbon economy”. 

European banks’ exposures to more carbon-intensive firms are already less than 5 per cent of their large exposures. For European insurance companies, pension funds and investment funds, exposures to carbon-sensitive sectors measure between 2 per cent and 8 per cent of their overall portfolios.

“Such changes in asset prices need not, in themselves, pose risks to financial stability. Rather, they may be symptomatic of a well-functioning financial system that channels investment towards more climate-neutral investments.”

Most banks are still failing to fully embed climate change into their strategy. Prudential Regulation Authority reported in 2018 that only 10 per cent of UK banks were taking a strategic, forward-looking view of climate risk, grounded in their long-term interests. The ECB also recently reported that “the vast majority of banks have not yet established internal processes that allow them to systematically identify and manage climate-related risks”.

Many emerging market economies are more vulnerable to climate-related risks such as rising temperatures and extreme weather events, notes the FSB. In 2011, floods in Thailand resulted in a 10 per cent reduction in GDP, and the value of major Thai equity indices fell by about 30 per cent in the following 40 trading days.

“Greater vulnerability to physical risks might also lead to a deterioration in sovereign creditworthiness, given the effects of natural disasters on tax revenues and fiscal expenditure,” writes the FSB.

Another study by Pictet Asset Management and the Smith School of Enterprise and the Environment at the University of Oxford recently found that emerging markets including China, India and Brazil were likely to bear the brunt of the damage from climate change. 

People in China could be 25 per cent poorer by the end of the century if nothing at all is done to slow the rise in global temperatures, this report finds, while India risks more than a 60 per cent shortfall in GDP per capita by the end of the century.

Laurent Ramsey, managing partner of Pictet Group and CEO at Pictet Asset Management said: “To solve and adapt to the effects of climate change will require a great deal of human ingenuity, technological advancement and the application of what we learn through experience and education.”

Overall, Pictet and Oxford University’s report suggests that global economic output per capita could fall by as much as half by the end of the century in the instance of unmitigated climate change.

Professor Cameron Hepburn, Professor of Environmental Economics and Director of the Smith School, draws attention to the recent coronavirus pandemic and the potential to ‘build back better’. “As we make clear, the vast fiscal and monetary packages governments continue to put in place to support their economies over the near-term can also considerably help efforts to limit global warming over decades to come if invested wisely.”