Extreme Weather in the World Economy

With the largest ever climate strike gathering 7.6 million people in September and activism having a direct impact on capital markets, the awareness surrounding this issue is increasing and the threat to financial stability is unmistakable. Investor activism is on the rise and there has been a surge in demand for environmental, social and governance (ESG) considerations. This awareness is, therefore, flowing directly into the financial sector, where, for example, Deutsche Bank relaunched two existing European, Middle East and African fixed-income funds with an ESG label in early October.

One of the risks of this shift is where businesses may face compensation demands as a consequence of their past behaviour. Although this may seem unlikely, the first ‘casualty’ of this nature was PG&E, who filed for bankruptcy earlier this year following the Californian fires in 2018. The huge liabilities faced and the claims that it failed to maintain equipment in preparation for dry weather led to the firm’s demise. The prospect of governments making direct demands for compensation links to the $200 million settlement against four US tobacco companies in 1998. This trend is likely to continue, and its severity will increase in the years to come.

Furthermore, investment may be stunted in areas impacted by extreme weather due to the damage to assets, which could lead to insurance premiums rising to become unaffordable for many firms. Between 2017 and 2018, a record-breaking $219 billion was estimated to be the cost of natural disasters, according to a report by Swiss Re. More worryingly, AXA warns that insurance would be unviable if world temperatures were to rise by another four degrees centigrade by the end of the century – which the UN predicts it will.

A third channel through which climate change could threaten financial stability is through transition risk, whereby the shift to low carbon emission technologies will lead to redundancy of extensive capital stocks. The automotive sector has already been hit and the collusive acts of firms in the industry are a testament to their struggle in adjusting to this radical shift. Volkswagen (VW), Daimler (parent company of Mercedes-Benz) and BMW were convicted of collusion against the introduction of clean emission technologies earlier this year, where two VW leaders were charged and where Daimler was fined $957 million.

However, there is a potential solution for companies facing such investment challenges and that is through green bonds, which are issued to support environmental projects. Launched in 2007, they have been used to finance projects aimed at energy efficiency, pollution prevention, clean transportation, and sustainable agriculture. Although it took eight years before the cumulative issuance reached $100bn, they now total $1tn and their momentum is growing. Apple raised €2 billion in green bonds to fund more energy efficient and recyclable products recently in November. The fact that demand for eco-friendly fixed-income bonds is on the rise meant Apple faced lower borrowing costs than previously issued debt. Despite these positive prospects, the market still suffers from patchy data and the lack of a standardised framework for measuring performance, combined with thin liquidity in what is a slightly fragmented market.

Moreover, this opportunity does not solve the transition risk if the European Systemic Risk Board drives forward with the agenda of ‘carbon stress testing’. Smaller businesses that lack the means to harness green bond technology face the risk of their business models becoming infeasible in the future, which could have the knock-on effect of leaving banks with vast unpaid debts. The acceleration of this rapid change becoming unmanageable is almost inevitable if we want to prevent the “tragedy of the horizon”, as explained by Mark Carney. This is where, by the time there is a global consensus for arresting climate change, we will no longer be able to prevent it.