Climate change is everything. This is the first in a planned series highlighting the pervasive impacts of climate change across all facets of our global society. Not only is climate change physically altering the planet, it is taking an increasing toll on human health, the supply chains for a host of products, and, as we discuss in this note, the financial services sector.

Climate change is now. The western U.S. is burning, hurricane-force winds have wreaked havoc in Iowa and Utah, and the Gulf Coast is still struggling to recover from several deadly hurricanes in recent years.

Consumers of financial services will bear the cost. Costs and availability of mortgages and insurance are already beginning to reflect climate change risks, depending on location, and this trend will likely grow.

Financial institutions are waking up. On September 9, 2020, the U.S. Commodities Futures Trading Commission released a landmark report that states in no uncertain terms: “Climate change poses a major risk to the stability of the U.S. financial system and to its ability to sustain the American economy.” The report provides a series of concrete recommendations for financial market participants, including regulators, financial institutions and asset owners, to execute the necessary transition to a low-carbon future without destabilizing the economy. Notably, the report reflects a consensus across a range of financial markets participants.

What should investors know? In this report we provide a digestible overview of the key categories of risk and potential impacts, how financial sector participants are beginning to respond, and what questions investors should ask their advisors about how they are factoring systemic financial risk into portfolio allocations.

Continue reading for our report overview, or download our full report Climate Determinants — Financial Services.

Overview: Transformative risks in the provision of financial services

Extreme weather and disasters fueled by climate change take a major toll on society in terms of human suffering, individual losses and systemic risk.[1] The financial services sector, which includes banks, insurers, investment service providers and asset management firms, is highly exposed to the potential costs related to climate change. The series of natural disasters in just this past year — including the coronavirus pandemic — has thrown these risks into even starker relief.

In the U.S. alone, there have been 273 weather-fueled disasters since 1980.[i] Altogether these events cost a staggering $1.79 trillion.[2] Looking just at wildfires, the 50 years leading up to 2015 averaged approximately $1 billion per year (inflation-adjusted). That figure jumped to $10 billion in three of the past four years.[3] While proving a direct link between the rise in weather-fueled disasters and climate change is complicated, an October 2019 scientific paper by the PNAS[ii] documented “an increasing trend in extreme damages from natural disasters, which is consistent with a climate-change signal…. with most pronounced increases in… catastrophic events. This pattern is strongest in temperate regions, suggesting that the prevalence of devastating natural disasters has broadened beyond tropical regions and that adaptation measures in the latter have had some mitigating effects on damages.”[4]

The depth and breadth of climate risks to the financial underpinnings of our society are only beginning to be fully appreciated. While insurance companies have begun to reflect climate risks in their policies and large investment banks are beginning to consider them in valuations, the complexities are not well understood by many investors, including many professionals.

The financial services community is beginning to respond in a more concerted manner, however. Notably, the U.S. Commodities Futures Trading Commission (CFTC) has just released a very detailed assessment of the various climate-related risks — physical, transition, and liability risks — as well as their impact across sectors. The report, a collaboration among more than 30 financial markets participants, offers a comprehensive set of recommendations for regulators, financial institutions and asset owners to carefully execute the transition to a low-carbon economy. This is a significant achievement, particularly in the current political climate.

However, while investors may not fully appreciate the nuances of climate risk, the markets provide nearly instant information on how they react to an exogenous shock to the outlook for a region, sector or company.[5]  A sudden shift in investors’ perception of the future risk of climate change on asset values could precipitate their decline, destabilizing investor portfolios and financial institutions’ balance sheets.

On average, there has been only a modest stock market response to large climatic disasters. Results, however, vary widely across disasters. Hurricane Katrina, which resulted in total damage of roughly 1% of U.S. GDP, triggered only a modest stock market reaction, with no discernible drop in the U.S. stock market index. The 2011 floods in Thailand, which hit Thai GDP with a 10% decline, resulted in a drop in the Thai stock market index of over 8% soon after the disaster and a cumulative drop of about 30% after 40 trading days. [6]

Market impact aside, the recorded costs of damage from such disasters are estimates of the spending needed to rebuild properties and businesses.[7] The full costs include investments not made because of the need to rebuild — investments that might have instead helped grow the economy. The true impact of more frequent destructive weather events may be immeasurable.

[ii] Proceedings of the National Academy of Sciences of the United States of America.

[1] International Monetary Fund – Global Financial Stability Report, April 2020 Chapter 5: Climate Change – Physical Risk and Equity Prices; May 29, 2020

[2] https://www.ncdc.noaa.gov/billions/

[3] https://www.nytimes.com/2020/09/16/us/california-fires-cost.html

[4] https://www.pnas.org/content/116/43/21450

[5] Ibid.

[6] Global Financial Stability Report, April 2020 Chapter 5: Climate Change – Physical Risk and Equity Prices; May 29, 2020

[7] https://www.washingtonpost.com/weather/2019/06/07/trillion-economic-blow-cost-extreme-weather-us-is-worse-than-we-thought/