The climate is changing
The way we invest must change too
Fifty Dutch banks, pension funds, insurers and asset managers signed the Climate Agreement last year in the presence of Finance Minister Wopke Hoekstra. The signatories committed to report on the climate impact of their financing and investments from 2020 onwards. In addition, the signatories will prepare action plans by 2022 intended to contribute to a reduction in CO2 emissions. Although the financial sector is sending a positive message by taking climate change into account, it is only the tip of the iceberg of measures that will be needed in the transition to a sustainable society.
Climate change is a fact. Prolonged droughts and cyclones that are growing in intensity are damaging critical infrastructure and agricultural yields. Businesses and investors used to use and embrace climate change as a way of making a positive contribution to the world. This did not take into account how they themselves were affected by climate change and transitions. The fact is, however, that drought, extreme weather conditions and floods are having an increasingly negative impact on companies’ financial situation. The damage caused by climate change is putting the brakes on the financial growth of businesses and even countries. A recent example of this is the impact that forest fires have had on Australia’s gross domestic product, which is estimated to be 1.5 per cent lower in 2019 (source: Accuweather).
That said, measuring the actual economic impact of climate change is still work in progress. While we can assess the direct costs of changing weather patterns and more frequent and intense natural disasters, most costs are beyond the horizon of traditional economic analyses. The economic impact of climate change will increase as the earth warms up, but the extent of the impact is difficult to predict. Much will depend on the policy measures we take today.
Central banks and financial regulators are increasingly acknowledging the impact of climate change on financial stability. For instance, in its report ‘De Nederlandse financiële sector veilig achter de dijken?’ (‘Is the Dutch financial sector safe behind the dykes?’), the Dutch Central Bank is calling on financial institutions to report on climate-related financial risks in their portfolios and state how they intend to mitigate them. The expectation is that this will soon become obligatory and that regulators will make climate scenarios a mandatory part of risk and portfolio management.
To date, financial institutions have in fact limited their analyses on climate change to estimating transition risks. These are the financial risks that financial institutions are exposed to during the transition to a low-carbon economy.
If for instance governments decide to introduce CO2 taxes or restrictions, companies with CO2-intensive operations will face major cost increases. For example, the introduction of a CO2 tax may have a major impact on the cement industry, given that it accounts for 5% to 8% of the global CO2 emissions. This would certainly be the case if these measures are implemented abruptly, leaving little time for companies to adapt. Transition risks may also manifest if there are sudden technological breakthroughs that allow for a rapid reduction in emissions or if market demand changes (possibly under pressure of changing laws and regulations).
That said, it is becoming increasingly clear that the transition to a low-carbon economy is not going fast enough to prevent global warming. According to a study published in the Proceedings of the National Academy of Sciences journal, human activity may push the planet over a tipping point, causing temperatures to rise even more than expected. This would trigger a rise in the earth’s temperature of between 4 and 5 degrees Celsius, instead of the 2 degrees Celsius that countries have undertaken to adhere to in the Paris Treaty. This is what the research refers to as a ‘heat era’.
Companies in the financial sector are therefore obliged to pay more attention to physical risks in their investment policies. These are risks due to climate-related damage, such as floods, droughts, storms and extreme rainfall. If this damage is insured, it has direct consequences for insurers’ business models and risk management. If it is not insured, and therefore has to be borne by the companies themselves, it can have an impact on financial institutions’ exposure in the form of loans, shares or bonds. The risks involved are not just confined to the Netherlands; the impact of climate change on some other countries and regions is expected to be much more serious, even if the warming is a ‘mere’ 2 degrees, as the figure below shows.
It is particularly crucial for financial institutions to understand that tackling financial risks and exploiting opportunities that climate change presents is not a one-off exercise. It has to become a permanent part of daily decision-making and portfolio management. Tackling climate change requires joint effort and collaboration, but financial institutions are ultimately responsible for managing the climate-related impact on behalf of their customers and shareholders. Customers stand to benefit if organisations tackle climate change proactively. This will reduce systemic financial risks and make a crucial contribution to the implementation of the climate agreement (Paris Treaty). While those who do not take action may not be severely affected in the short term, failing to take action may have a boomerang effect when the energy transition accelerates and – if we are not able to turn the tide in time – the increasingly negative (financial) impact of continued global warming makes itself felt.
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