The Impact of Climate Change on Financial Institutions
Human activity has already caused the planet to warm over 1°C since the preindustrial era. Cyclones, droughts, floods and unpredictable monsoon seasons are increasing in frequency in all parts of the world. The increasing global average temperatures will continue to make weather events stronger and more frequent. Without immediate intervention at the current rate, the average of the land and ocean temperatures in the northern hemisphere could increase by at least 1.46°C from the preindustrial levels.
In India, the frequency of storms that have caused significant damage to property and life have been increasing in frequency and strength since 2017. As the land and ocean temperatures continue to increase, so will the strength of the cyclones. Cyclones will last longer and cause more significant damage.
Damages caused by extreme weather events
During the 2015 South India Floods more than 500 people were killed and over 1.8 million (18 lakh) people were displaced. With estimates of damages and losses ranging from nearly ₹200 billion (US$3 billion) to over ₹1 trillion (US$14 billion), it is one of the costliest natural disasters to occur in India. In 2019 alone floods across India claimed 161 lives and 7,97,450 people were evacuated with estimated damages to property well above US$5 billion (₹37,000 crore.) The unprecedented destruction of floods and cyclones is attributed, by environmentalists, to unscientific developmental activities undertaken in recent decades.
In Uttarakhand hydroelectric projects contribute to the ecological imbalance in the state, with flows of river water restricted and the streamside development activity contributing to a higher number of landslides and more flooding. In Tamil Nadu, extensive and costly projects begun in 2013 to desilt city storm drains however, it was reported after the 2015 floods that the drains have been shoddily built and improperly designed. The incongruity of cities such as Mumbai where slums with temporary structures with metal roofs are built next to skyscrapers with glass windows is a recipe for disaster.
Climate change will have a far-reaching effect on a wide variety of firms, sectors and geographies in a way that will be very hard to predict. While climate-change related shocks are yet to strike at a level that allows the study of its quantifiable economic impact, early research shows that rising sea levels and the increasing scarcity of clean water will deliver a shock of a magnitude sufficient to trigger the financial system’s amplification mechanisms.
The damages caused due to cyclones and floods from the year 2010 to 2020 is estimated to be well above $75 billion. Ceteris paribus, during the period of 2021 to 2029, damages to property could go up to $276 billion which to put in perspective, is about 10% of India’s GDP in the year of 2020.
Risks posed by Climate Change
The corporeal damage to property will not be the largest risk that the economy will face. Two additional risks that financial institutions face are physical risks and transition risks. Physical risks will be seen when the value of immovable property such as land and buildings fall due to extreme weather events. It is assumed in many studies that the fall in asset prices will be gradual. However, it is highly likely that the economy sees a non-linear rapid fall in asset prices which will have a disruptive effect the financial system.
On the other hand, the global response to climate change is to reach “net-zero carbon emissions”, banks will face transition risks while adjusting to a low-carbon economy. One of the biggest factors that could amplify transition risks are the investments banks have made in the fossil fuel industry. In 2018, five coal-fired power projects with a combined capacity of 3.8GW were financed by 25 commercial and state-owned lenders, this entailed of $850 million. In order to reach net zero carbon emissions, coal fired power projects need to be shut down completely.
Extreme climate events also pose a threat on all the aspects of food security. It causes intensive damage to crops over a short period of time. The agriculture sector that contributes about 15% to India’s GDP sees about 1.5% loss in GDP each year, that is attributed to climate change. By 2030, rice and wheat are likely to see about 6 to 10% decrease in yields. On the other hand, crops such as the soy beans and potato are expected to benefit from an increase of CO2. However, this positive effects not expected to last for more than 15 years. Extreme weather events have caught attention of agrarian experts who have now started focusing on natural farming to arrest the impacts of climate change.
The effects of climate change are also a threat to property and casualty (P&C) insurers. More frequent calamities will threaten company business models and make insuring some risks unaffordable for customers or unfeasible for insurers. Therefore, stakeholders are likely to demand that insurance solutions go beyond the traditional risk transfer to explicitly address risk mitigation. Additionally, financial markets can rapidly reprice assets that are exposed to climate risk, affecting insures’ investment portfolios and their own market valuations negatively.
These risks on their own seem manageable to an extent and while it may seem like these risks are separate, in reality they will interact. The goals set by many governments and companies to decrease carbon emissions have been deemed by environmental activists as “too little, too late.” In fact, many scientists also believe that the climate crisis has reached a point of no return. It is highly likely that the impact of increasing global temperatures and the resulting increase in extreme weather events, corporal damage, the sudden decline of asset prices along with the transition risks will have a destabilizing effect on the financial system in the latter half of 21st century.
Mitigating the risks posed by Climate Change
An increasing number of banks have been taking actions to address climate related risks however they are not yet taking sufficiently comprehensive, strategic and long-term approaches to address climate risks. In order to mitigate climate related risks financial institutions can heighten the due diligence and introduce the use of metrics that track their exposure to climate risks. Within the TCFD framework metrics focus on the firms’ carbon footprint, carbon intensity and financed emissions are tracked in order to make better decisions on capital allocation and risk assessment. They can also integrate climate related risks into their assessments of borrower credit risk and investment decisions. Additionally, financial institutions can integrate climate risk management into the institution wide governance, strategies and risk management frameworks. Firms must begin to place accountability and management responsibility of climate-related risks with their board and senior management. They can also use scenario analysis to identify and assess the potential implications of climate change and test the resilience of all the firms in the industry.
The agro-based industry needs to focus climate-tolerant crops such as the Swarna rice and introduce IoT based solutions to ensure efficient water and nutrient management systems, the evaluation of carbon sequestration potential of different land use systems and identifying cost-effective methane emission reduction practices in ruminants and in rice paddy.
Insurance providers must begin stress-testing their total exposure against projected climate hazards in order to understand the impact of climate-related risks on their portfolios using advanced-analytics techniques.
Governments and authorities on the other hand can crack down on unregulated urbanisation and ensure that cities are built in sustainable and scientific manner. Most financial authorities have engaged in awareness raising of climate risks and many have surveyed the institutions they supervise to understand how they manage climate risk. Some authorities have issued or are in the process of issuing supervisory expectations, which tend to cover some set of institutional risk management elements.
The most fundamental cause of any damaging crisis is the spread of a belief in a more stable future. The belief that it safe to borrow and lend on the scale that we see today. The climate crisis is unavoidable. Financial institutions and governments will have to respond to this crisis with not just an arsenal of ex ante tools but they must also maintain a strong financial capacity in order to preserve and maintain the human right to health.
