Physical and transition risks could combine to increase destabilisation, but report cites “numerous sources of uncertainty”.
Both the physical risks of climate change and a disorderly transition to a low-carbon economy could impose severe strains on the stability of the global financial system, according to a new report by the Financial Stability Board (FSB).
As well as potentially causing sharp falls in asset prices and destabilising the financial system, climate-related risks could distort and undermine market responses to shocks, further eroding stability, said the report, titled ‘The Implications of Climate Change for Financial Stability’.
Climate risks could lead to “abrupt” risk premia hikes across a wide range of assets, which could in turn alter price movements in multiple sectors and jurisdictions, also amplifying credit, liquidity and counterparty risks, posing unpredictable challenges for financial risk management techniques.
“Such changes may weaken the effectiveness of some current approaches to risk diversification and management,” said the FSB, warning of knock-on threats to financial system resilience and the possibility of a “self-reinforcing reduction in bank lending and insurance provision”.
However, the report acknowledged the large scope for uncertainty over future scenarios, including the extent and impact of temperature rises, the effectiveness of mitigating policy responses in the public and private sector, and the availability of accurate data on exposures and effects.
“Risks to the financial system from climate change tend to be particularly uncertain in both their severity and the time horizon over which they might crystallise,” said the report, noting also a high degree of dependency on measures taken by policymakers.
Impact on asset prices
The FSB report says the impact of the physical risks of climate change on asset prices could be “contained” if the rise in mean global temperature remains within two degrees Celsius of above pre-industrial levels, citing a recent analysis estimating a fall in financial asset values of 0.7-4.2%.
But the report explains that such estimates are “subject to numerous sources of uncertainty”. These include the future path of global greenhouse gas emissions, the assumptions underpinning models use to estimate the impact of risks on asset prices, and the use of different future cashflow discount rates.
With such high levels of uncertainty, the FSB says potential outcomes are subject to “considerable tail risk”, adding that a “self-reinforcing” acceleration of climate change and its economic impacts could decrease asset prices and increase uncertainty. It further warns that market and credit risks could be concentrated in specific sectors and geographies.
“Some emerging market and developing economies (EMDEs) may be particularly vulnerable to physical risks, given their higher exposure and sensitivity to the effects of climate change,” the report said.
The FSB also notes that the response of insurance firms to greater claims and underwriting losses arising from the physical risks of climate change could pose a systemic risk. A large-scale withdrawal of coverage or increase in premiums could lead to more companies and households being exposed without adequate insurance cover, thus amplifying risks to financial stability.
The primary transition risk posed by climate change stems from sudden changes in public policy or use of technology, says the report, warning radical changes in policy in response to the increased materialisation of risks could lead to the financial system being hit by physical and transition risks in tandem, causing higher levels of destabilisation.
The FSB report suggests that the risks to the financial system posed by an orderly transition appear “contained”, both in terms of impacts on equity and bond portfolios and the aggregate exposure of banks, insurers and institutional investors.
Interaction of physical and transition risks
But it asserts not enough research has been conducted into the interaction of physical and transition risks, noting also that existing analyses of sectoral exposures could underestimate emissions levels across supply chains and thus the impact of transition. “Analysis based on sectoral exposures might also conceal concentrated exposures to a given counterparty, or borne by certain financial institutions,” it warns.
The impact of climate-related risks may be distorted as they are transmitted through and amplified by the financial system, the report adds, noting the possibility of feedback loops. Examples include reductions in lending by banks, and in coverage by insurance firms, lead to reduced support to the real economy, thus amplifying the effects of climate-related risks on the non-financial sector, resulting in lower growth rates which in turn could increase losses faced by financial institutions.
The report acknowledges the measures being taken by policy-makers and financial institutions, particularly macro-prudential regulation, emissions reporting, scenario analysis and the growing integration of climate risk management into due diligence, investment decisions and governance.
“However, the efficacy of such actions taken by financial firms may be hampered by a lack of data with which to assess clients’ exposures to climate-related risks, or the magnitude of climate-related effects,” the report says.
The FSB said it will conduct further work to assess the availability of data through which climate-related risks to financial stability could be monitored, as well as any data gaps. It is due to complete the work by October 2021.
The FSB is mandated by the G20 finance ministers and central bank governors to monitor the financial stability implications of climate change.