Humans have caused a rise in the earth’s temperature- up to 1 degree Celsius above preindustrial levels, as stated by the Intergovernmental Panel on Climate Change (IPCC). Prolonged wildfires, deadly cyclones, flooding events, catastrophic storms, and more are regularly occurring. These natural calamities clearly point to the devastating impacts of climate change. Researchers warn that climate change’s ecological, social, and economic effects could easily rise to fatal levels, given the current predictions. According to experts, the impacts of global warming on financial markets could influence investment decisions and could lead to certain financial stability risks.
Suppose temperatures continue to increase at the current rate to 4 degrees Celsius above preindustrial levels over the coming 80 years or so. In that case, the international economy will likely experience an approximate $23trillion loss per year. The damages would far exceed those during the 2007-2008 financial crisis.
The pace at which global action and effort are taken to reduce emissions will determine the impacts over the coming years. It is now binding on decision-makers- from financial and infrastructural services to tax and energy policy- to reduce the effects of human-induced climate change. And to enable a suitable transition to the United Nation’s target of net zero emissions by the year 2050. Today, regulators need to take the correct steps to ensure that financial systems are protected from climate-related shocks.
How is Global Warming Affecting Financial Markets?
The impacts of global warming on financial markets are likely to increase or decrease- depending on human efforts and actions. In a financial market, the market risks are risks that have the ability to disrupt the functioning of the whole system. It may ultimately result in the destabilization of the real economy. According to the Financial Stability Board’s report on ‘The Implications of Climate Change for Financial Stability– at the topmost level, the risks or impacts of global warming on financial markets are generally divided into two types:
The Physical Risks: linked to the regular climatic conditions and prolonged ecological changes.
The Transition Risks: caused by the technological and policy changes required to accomplish a greener economy.
These risks could significantly affect the value of financial institutions and instruments. The extent of these risks and their relationship depends on climatic change and the course of action to avoid them. They also depend upon the efficient or inefficient transformation of the economy into a low-carbon one.
While financial markets continue to experience transitional and physical risks of global warming, they also increase the risks by regularly providing substantial financing to practices that increase climate change. During the years 2016 to 2018, the six largest Wall Street banks in the United States contributed over $700 billion toward fossil fuel financing. According to a study conducted in 2016, the largest insurers held almost $528 billion in fossil fuel investments. Over the past three years, the most prominent asset managers have increased their holding of assets in fossil fuel industries and other carbon-intensive industries by 20 percent.
The Physical Risks
The rise in natural calamities like droughts, famines, floods, and heatwaves could result in severe and massive physical losses for financial institutions. Banks, insurance companies, and several more financial institutions that have direct and indirect exposure to various assets and industries will be affected. Devastating impacts occurring at an influential and interconnected financial institution or numerous small institutions could affect the entire financial system.
Throughout 2016, 2017, and 2018, the United States lost around $1 billion due to 45 natural disasters that occurred across the country. According to the Urban Land Institute, in 2014, dangerous climatic conditions caused severe damage to property and infrastructure. Total global damage was experienced- exceeding $150 billion every year. The property and infrastructure of financial institutions are likely to get damaged the most, among other parts of the economy. For example, in the case of a deadly flood, it is possible that a mortgage owner will lose his house and might not be able to repay the whole amount due to the bank. If this happens to a larger group of people, banks will then struggle as their capital levels become more limited. As economic conditions worsen in vulnerable communities, it will eventually lead to more significant losses within financial institutions.
The Transition Risks
Besides physical risks, the financial market could gradually destabilize due to rapid losses to carbon-intensive assets caused by the much-needed transformation to a green economy. If decision-makers took the necessary efforts to decarbonize the economy or if technological advancements made the shift more effortless and more attractive, carbon-sensitive assets could lose value. The transformation can occur eventually without much destabilization. For this, financial institutions and investors would need to motivate it by pricing in the effects of a transition to a green economy. And gradually, over time, they also rearrange their risk management models and structure.
The policymaker’s and regulator’s duty is to take care of worst-case scenarios so that families, taxpayers, and workers don’t get affected or have to bear any burdens. Today, there is a need to make significant efforts to protect the financial market from global warming and climate change risks. It would help facilitate a better transition and reduce the chances of a climate-driven financial crisis. It can also help in preventing climate critics from using the financial destabilizing as an excuse to oppose the regulations and policies necessary to reach a net-zero emission by the year 2050.
The impacts of global warming on financial markets and institutions fall directly under the jurisdiction of financial regulators. Policymakers need to realize this emerging financial risk and make efforts to strengthen the resilience of financial markets. Few financial authorities are currently searching for ways to mitigate climate-related financial risks. Delaying further action will increase the likelihood of a climate shock- disrupting the entire financial system and affecting the broader economy. The world should not have to struggle due to the delayed actions of regulators.
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