Will Climate Change lead to the next Financial Crisis?
Are the markets under-reacting to climate change information? How can climate change be a threat to the financial markets?
Prologue
It doesn’t matter if people actually read my articles, I’m not an expert in climate change (yet), but I know the end is imminent if we don’t act now. I’m writing these articles to make people aware of what’s happening around us. Sooner or later, people would look back at some fictional doomsday films produced in the 21st century and wonder if it was based on true stories. You could say climate change is like a weird cult, but you are in it whether you like it or not. The more informed we are about the environment, the more powerful our voices will be, and we can use that voice to encourage policy makers to take actions. People must know that we don’t need to make a choice between economic development and environmental sustainability, but we can make a choice between prosperity and austerity. At the end of the day, your reality is confined to your senses; you can always choose not to see, but you won’t be able to choose if there is no reality to see.
Understanding Climate Change
Without reading any charts or numbers, you probably have witnessed or experienced climate change events in recent years. From the heat waves and floods in Asia to the hurricanes in the United States and droughts in Australia; these recent extreme weather events might all be indicators for climate change. However, is there a strong link between extreme weather events and climate change? The short answer is yes, and it is very likely that these extreme weather events were all signs of a changing climate.
According to the reports of UN’s Intergovernmental Panel on Climate Change (IPCC):
“A changing climate leads to changes in the frequency, intensity, spatial extent, duration and timing of extreme weather and climate events, and can result in unprecedented extreme weather and climate events,”
Let’s examine the correlations between these events and how they are connected to climate change,
Greenhouse Gases — CO2
When we look at time-series graphs, we normally only focus on certain time periods that are not too far back into the past since too many unaccountable factors would disturbs the significance of our analysis, but it still depends on the type of data and the type of analysis. The graph above has a scale of 400,000 years and it measure the CO2 level with air bubbles trapped in Ice. The interesting thing is that the CO2 level during the Ice Age was around 200 parts per million (ppm) and when it started to warm up towards the Interglacial Periods, the CO2 level would reach to around 280 ppm. By looking at the transition between Ice Age and Interglacial Periods, we could observe that we are in the 4th cycle of the interglacial period. In 1950, the CO2 count was just about the normal level of the Interglacial period around 280 ppm. However, after 1950 a clear spike of CO2 level can be observed; another 120 ppm of CO2 count is added to the Earth’s Atmosphere. Shockingly, that is almost the same amount of CO2 level as the difference between the troughs of the Ice Age and the peaks of the Interglacial. A simple logical explanation would be that Homo-Sapiens step in with the use of fossil-fuels that increase the CO2 count to 400 ppm.
This alone should already struck bombs for many of you, it certainly did for me when I first saw it. Earth has been autocorrecting the CO2 levels throughout the transitioning of the periods, yet CO2 level have spiked during the age of Homo-Sapiens. Several politicians have doubted the effects of human activities on climate change for a while, maybe it’s time for them to have a look at the science.
Most people learned about the effects of Greenhouse gasses in school, but if you haven’t learned about how high levels of Greenhouse gases lead to a higher Earth temperature, watch this video. According to NASA’s ongoing temperature analysis on Earth, the average temperature have increased 0.8° Celsius (1.4° Fahrenheit) since 1880. In addition, the temperature is not just getting higher, but at an increasing rate. More specifically, the rate of temperature increase between now and 1950 is almost 3 times higher than between 1880–1950.
Science tells us that warmer air carriers more water vapour and water vapour is associated with downpours. In other words, the hotter the temperature gets, the more ferocious the rains will be. The graph above shows a steady uptrend of an increasing downpour in the United States. The increased rainfall lead to the increase rates of flooding in cities and coastal areas. The heavy downpour also causes soil erosion, which in return harms the agricultural industry.
Furthermore, a more direct effect of rising temperature is the increased number of droughts around the world. As temperatures increase, more water evaporates, and causing soil moisture levels to drop, which is essential to many agricultural products. Climate scientists have found higher temperatures exacerbates higher risks of droughts. The network of these climate events is vast and there are still many cause-effect relationships being discovered frequently.
To put matter into perspective, according to the EM-DAT international disaster base. Number of floods have increased 15 times since 1950, number of deaths resulted from droughts increased 10 times since 1996, number of wildfires increased 10 times since 1950, and number of extreme temperature events increased by 20 times in the span of 68 years.
If the impact of these natural disasters are hard to imagine, to give a graphical perspective, I urge you to watch the movie: The Hurricane Heist.
If you want to know more: https://www.emdat.be/publications
There are a lot more shocking statistics that I can throw at you to help you understand what’s going on. Climate change is not just about temperatures getting higher and a need to install an Air Conditioning unit in your room. All these natural events have incurred tremendous environmental and socio-economic costs, the economy is also taking a heavy hit. Traditionally we think natural disasters can’t be avoided, but we do have the power and technology now to make us more prepared for it and even prevent it to happen. The rise of temperature seems imminent, but we can start changing our way of life and way of business bit by bit to slow down the rate of increase. We can only help to minimise theses losses if we start to make a change in our attitudes towards the environment.
Understanding the economic impacts of climate change
Despite the obvious immediate social-economical impacts of extreme weather events, there are also long lasting impacts of climate change. Many studies have been done to understand that long-lasting impact of climate change; especially the economic impacts on agricultural industries and the global food supply.
Here we take a look at the Indian region as it is one of the regions that are most exposed to climate change since the agriculture sector is their most prominent sector of the Indian economy; any exposure to climate change will have a direct lasting impact on the lives of 1.2 billion people. Moreover, climate of a region is the most important factor in determining the characteristics of the agricultural production of that particular region. A small increase in the temperature can reduce the growing duration of corps and also reduce the final yield. The major impact of this is evident during the reproductive stage of a corp and can potentially reduce the yield by 80–90%. Further study even shows an 1°C increase could result in a drop up to 31% of rice crop yields in India. In addition, changes to temperature and downpours could also lead to outbreaks of pests and diseases that affect the aggregate agriculture production; hence, food security. Furthermore, climate change also influences the monsoon season, frequent heat waves, extreme downpours, draughts, floods; which are all threats to the agricultural sector, the consequences are astronomical.
India is a perfect example of the risks that current developing countries are facing. Most of these countries are poor and highly dependent on Agricultural industry for their survival. However, they are also facing ongoing social and ecological problems with growing population and rapid urbanisation. All these problems could result a worsened environmental impact that ultimately further damage their economy. In the worst case scenario, the South-East Asia region could lose up 25 per cent of GDP annually by 2100.
Subsequently, countries like India target to half their greenhouse gas emissions by 2050 to cope with many climate risk uncertainties to ensure a certain quality of life. However, India’s efforts alone would not make a lasting change. It takes a global effort to reduce the pollutants and greenhouse gas emissions. When we tackle climate change, we no longer live by the constraints of geological and political boarder; at the end of the day we are still citizens of the world and shared inhabitants on Earth.
Understanding the impact on Financial Markets
Insurance industry
“I’m standing in front of a burning house and I’m offering you fire insurance.” — The Big Short.
As I mentioned before, extreme weathers have been a regularity in the late 2010’s. According to Swiss Re, insurance companies paid out $144bn to losses from natural catastrophes and man-made disasters. The purpose of insurances is to reimburse individuals or firms for losses on their assets. It is commonly defined as the provision against catastrophe and is the pooling of risks. One of the general methods of measuring risk is to look at events in the past and assume that those past events adequately reflect the expectations for the future. However, accessing risks for climate change poses a great challenge for the insurance industry; climate scientists find it difficult to predict climate change risks with results of past climate change events. Accessing the risks for climate change should be based on future expectations not what happened in the past.
Insurance companies are the first-line of defense for societies against climate change. However many insurance companies have considered climate change as an issue to their business model. A 2018 study found that only 38% of insurance companies consider climate change as an issue for their business. Traditional insurance companies are over-confident in the way they deal with climate change. The commonly used method was to adjust policies on a yearly basis to adapt to science of climate change. However, reports have found that annual adjustments to manage climate risks are not effective due to the sudden change of climate associated risks that occurs in non-linear ways. Subsequently, those insurance companies that manage to adapt turn to climate scientists in developing new ways of assessing climate risks and make efforts to more accurately price their insurance policies.
On the other hand, many costs incurred by natural disasters are often not reimbursed since they were not insured. Politicians and business leaders have to view climate change as an actual risk to the core of their operations and a potential threat to their well-being. Without the proper insurance, it becomes immensely difficult to defend against climate change. As evident by the recent wildfires in California, many businesses incurred tremendous losses, if they were not insured, it will be tremendously difficult to get back on their feet.
Lastly, insurance companies could cut down their loss to climate change by investing in sustainability such as low carbon economy. Insurance companies being on the frontline in the battle against climate change could incur tremendous short-run costs that could potentially affect their costs in the long-run. It’s a fact that Natural disasters lead to economic devastation, if a large number of natural disasters and extreme weather events occur in a short period of time, it’s simply impossible for insurance companies to remain profitable, the insurance industry will collapse, and financial crisis will not be lagging far too behind.
Are the markets under-reacting to climate change?
According to the chart above, climate risks lead to direct physical impacts on assets owned by individuals, and this causes a fluctuation on the value of those assets, and eventually lead to instability and efficiency of financial markets. Traditional asset valuation models relies on the efficient-market hypothesis; where in short, stats that asset prices fully reflect all available information. Nobel laureate such as Eugene Fama have long supported this hypothesis. However, many have blamed the recent financial crisis on over-trusting the members of financial institutions behaving completely rational. Thus, many have turned towards behavioral finance in explaining the anomalies.
A study by Harrison Hong, et al published in October 2018 investigated whether stock markets are efficient in reacting to information about drought trends by looking at the food related stocks. They found that many countries that were affected by droughts have excess return predictability on their food stocks. In other words, Food stock prices are under-reacting to climate-change informations. This study is highly relevant for business practitioners and policy makers to accurately understand the impacts on the financial markets. However, there are very few academic studies done on the association of climate risk on market efficiency. There is an increasing worry on how markets are being too optimistic in reacting to negative information on stock prices. Accurately valuing risks and return becomes immensely difficult if climate information have to be taken into account.
The 2008 Financial crisis happened 10 years ago, many banks and financial institutions have learned their lessons since; banks are safer today compare to the past, but financial systems are still vulnerable. The challenge remains for regulators to search for indicators that could trigger the next global financial crisis. Reforms on the financial systems were placed after the last financial crisis, but many of those reforms are now being water down. Many deregulations of the reforms have increased the risk taking behaviors of participants of the financial systems. The financial stability of markets are threatened by many unseen factors; certain practitioners and lobbyist believe certain regulations would hinder business success, but the costs of financial crisis is far greater than the costs business pay to meet the current regulations.
Threats to financial stability are to divers and lead to devastating events. As evident by our history, when financial systems break down, the economy suffers and unemployment increase. A need for a strong crisis management system is of a necessity.
“An ounce of prevention is worth a pound of cure”
— Benjamin Franklin
Invest in the future
The market has gotten harder to predict with new evidence against efficient-market hypothesis and support for gradual-diffusion of information.
For developing countries, the net impact of food security and related items are exposed to global environmental change and climate change. Coping with the impact of climate change in the agricultural industry requires the investment of infrastructures that carefully manage soil, water and biodiversity. In my last article, profiting by saving the environment, I mentioned sustainable investments that focus on overall “efficiency” are key investments in the future. The energy industry is under the most dramatic change. The coal industry is more or less finished as evident by many nations such as Germany shifting away from coal production. The oil industry led to many of the great innovative technologies that we use today, but ironically those technologies are not turning into threats of the oil industry. Many technologies are leaving crude oil and turning into electricity and business practitioners and policy makers are increasing their preference for renewable energy. The most prominent example is Saudi Arabia’s ambitious 2030 plan to revitalising the economy to a more financial and service focused economy. A country built on oil money have realised threats to their main source of income and 2030 is only a mere 10 years in the future. If the biggest player in the oil industry plans to leave the market in 10 years, we might be witnesses of the next global financial change and a new political climate.
Conclusion
When Galileo Galilei proposed his idea of Earth revolving around the sun in the 16th century, it upset many traditional beliefs and he was arrested by the church and forced to recant his idea. He replied the famous phrase “And yet it moves”. People today have interpreted this phrase as “it doesn’t matter what you believe; these are the facts”.
Despite many people not believing in the facts of climate change, we offer should offer them the same reply “And yet it moves”. As we continue the “if it ain’t broke, don’t change it” mindset towards the environment, our actions could just trigger the next financial crisis, and the results would be far greater than the one prior.
Recommended reading:
I’m a big fan of Jeremy Grantham, not just because he is a legendary investor, but he is fighting climate change at the frontline. He has a lot to say about climate change and the financial markets.
I’m just a guy behind a laptop that like to research about the topics that I’m interested in. I’m no expert in environmental science nor sustainable finance (yet). I look forward to any of your comments and opinions that could help broaden my knowledge in this area.
