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Ripple Effects of Global Warming

Biranchi Mishra, Chief Risk Officer at Netafim Agricultural Financing Agency (NAFA), writes about risks that arise from global temperature rise:

Ripple Effects of Global Warming

The Sixth Assessment Report (AR6) of the Intergovernmental Panel on Climate Change (IPCC) unequivocally concludes that human influence is behind the warming of the climate system. The earth has already warmed by 1.1 since the industrial revolution started (average temperature between 1850-1900 and 2009-2018). The international climate agreement (2015 Paris Agreement) aims to hold the increase in global average temperatures to ‘well below 2°C above pre-industrial levels’ while ‘pursuing efforts to limit the temperature increase to 1.5°C.’

As part of the Paris Agreement process, countries have submitted nationally determined contributions (NDC), a promise of global emissions reductions that the government intends to achieve. Although these reduction commitments are significant, it is unlikely to limit warming to 2°C and might result in a warming of 2.5-3°C by 2100 and continuing into the 22nd century. In the best-case scenario, even if the world manages to hit these ambitious targets of 1.5°C or 2°C, the impacts will still be severe, leading to intense heat waves, more intense precipitation, and severe and frequent droughts, among other phenomena.

The climate-related risks arise primarily from stranding of assets, both tangible ones like mines, factories, buildings and intangible ones like intellectual property and company and brand reputation). The risk could arise from (i) acute weather-exacerbated events such as floods, hurricanes, droughts, wildfires or (ii) chronic trends like rising average temperature, rising sea level, etc. (iii) transition to the low carbon economy through tighter government policies in greenhouse gas emission (carbon taxes or premature closure of the facility), (iv) technological changes (cheaper renewable energy sources), (v) bottom-up consumer pressure for sustainable products and services or due to legal litigation and (vi) reputational risks.

Physical risks directly affect assets and the companies that own assets through exposure to hazards and indirectly through supply chain disruption and legal liability concerning the duties and responsibilities of corporate management or a company’s board of directors. The other indirect risk can be the effects of heat stress on worker productivity. The International Labour Organization (ILO) estimates that by 2030, when the global temperature rise by 1.3°C, the share of total working hours lost will be 2.2% or the equivalent of 80m full-time jobs (up from 1.4% and 35m jobs as recently as 1995). In monetary terms, it estimates this loss at $2.4 trillion in purchasing power parity terms compared to $280 billion in 1995, meaning a net loss of over $2.1 trillion in 35 years of climate change alone.

Understanding the size of the transition to the low carbon economy is essential to visualise the quantum of transition risk. Emissions need to start dropping quickly and sustainably to achieve the goal of keeping warming below 1°C by 2100 from now (2°C from the beginning of the industrial revolution). The whole global economy, especially electricity and heat production (25% of GHG emissions), industries (21%), transportation systems (14%), and agricultural practices (24%), must be thoroughly over-hauled to reach net-zero emissions by 2050.

Transitioning to the low carbon economy in line with the Paris Agreement will require $9.2 trillion in annual average spending on physical assets, 38% more than today, equivalent to half of global corporate profits and one-quarter of total tax revenue in 2020.

Climate risk transmits to financial risk through operational, credit and market risks. At the micro level, individual firms and households get impacted by property damage, business interruption, loss of income, changes in demand, and falls in asset valuation through asset stranding. The macro economy is affected by price shifts, productivity changes, socioeconomic changes, or labour-market frictions leading to financial risks.

Operational Risk

The climate risk transmission as operational risk is through acute & chronic climate hazards either by destroying the factories, supply lines, warehouses, data centres, or bank branches. Neglecting or failing to manage climate risks or adequately disclosing exposure to such risks can lead to legal and reputational risks for the organizations. Business decisions around aligning business practices with the net-zero transition or adapting to the physical impacts of climate change can cause significant strategic risks or create business opportunities for the financial institution.

Physical climate impacts causing operational risk on a large scale can have ripple effects across supply chains and through to markets, customers, and financial counterparties. The Thailand floods of 2011, which significantly affected global semiconductor production and had ripple effects across supply chains, is an excellent example of the macro effects of operational risk.

Credit Risk

Operational risk can be a vital channel from climate to credit risk. Organizations or projects vulnerable to extreme weather impacts or abrupt policy changes will have a more significant business interruption, resulting in a loss of revenues and profits and an increased PD or fall in asset value and additional credit risk for a lender. Pricing effects through markets for inputs (raw materials) and outputs (products) can also lead to higher credit risk. Increased counterparty credit risk resulting from climate change can transmit into the financial sector, posing a potential threat to financial stability if it occurs broadly enough.

Sectors reliant on fossil power plants or oil & gas will witness sector-wide asset stranding and credit risk for financial institutions heavily exposed to these sectors and, on a large scale, can impact the financial stability. Climate risk increases the concentration risk for insurers, especially in physical climate risk in vulnerable geographies, increasing the credit risk in case the insurers decline insurance coverage. Large numbers of insurers withdrawing their coverage of certain climate-related risks will households and firms without coverage, potentially amplifying the resulting risks to financial stability.

Liquidity Risk

Liquidity is paramount to financial institutions, and they are particularly affected by climate risk impacts on liquidity. Climate risk drivers can prompt depositors to draw down deposits from banks and debtors to draw down credit lines simultaneously, increasing (worsening) loan-to-deposit ratios. Evidence suggests that this does occur due to physical climate risks, specifically in the wake of natural disasters, as households and corporations withdraw deposits and draw on credit lines to finance cash-flow needs for recovery. Given the broad reach and potential severity of climate impacts, it is possible for liquidity risk to be a source of systemic risk to the banking sector and to threaten, therefore, financial stability, necessitating intervention by the central bank.

The most potentially concerning source of systemic liquidity risk would be a ‘climate Minsky moment’ in case of a wholesale, abrupt and broad-based re-evaluation of climate risks by markets, causing massive repricing of assets and a pro-cyclical crystallization of losses. If severe enough, such a climate Minsky moment could provoke a market-wide liquidity crunch more severe than the 2008 financial crisis.

Market Risk

At the systemic level, climate risk translates into market risk through repricing, dislocation effects, and asset stranding. The repricing effect is an important channel through which anticipated unrealized physical or transition risks can more quickly and tangibly impact physical assets such as housing or financial assets such as shares and bonds. Climate risk could break down typical correlation patterns between assets, reducing the effectiveness of hedges and challenging banks’ abilities to manage their risks actively. When the market price-in climate risks drivers, there is likely less potential for unexpected price movements or volatility. Abrupt repricing has been relatively infrequent, partly due to the insufficiency of governments’ and companies’ actions for reaching commitments such as the Paris 2°C target. We can expect repricing and market risk in the years ahead as climate policy tightens.

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