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How to prevent climate change from destabilizing financial markets

Early and orderly rollout of policies to control carbon emissions and limit global climate change will help the financial system transition to a green economy, according to a ‘climate stress-test’ of financial institutions.
April 4, 2017

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In an expansive study published last week in Nature Climate Change, an international team of researchers performed a ‘climate stress-test’ of financial institutions. They wanted to know how much the uncertain, delayed, and sudden implementation of climate policies could lead to destabilizing shocks that propagate throughout the financial sector.

The study is part of a larger debate over whether policies designed to help meet the goal of limiting warming to 2°C globally will be good or bad for the economy as a whole. Some past studies have looked at the risk of economic losses from extreme weather events. Others have estimated the value of ‘stranded assets,’ fossil fuel reserves that companies wouldn’t be able to develop due to carbon regulations.

The new study takes a broader view. The researchers say fossil fuel providers aren’t the only firms whose balance sheets will be affected by greenhouse gas regulations. Instead, they define five broad sectors of the economy where climate policy will have an impact: fossil fuels, electric utilities, transport, energy-intensive manufacturing, and housing.

The researchers reviewed information from a commercial database on 14,878 EU and US companies and 65,059 shareholders, and used this to reconstruct the portfolio of each shareholder. What they found was striking. Direct holdings in the fossil fuel sector by any one financial institution are relatively limited, ranging from 4 percent to 13 percent of portfolios, depending on the type of investor. But the total investments in all sectors of the economy where climate policy could have an effect are extensive, accounting for 36 percent to 48 percent of portfolios.

Moreover, many financial institutions hold equity in the financial sector itself—roughly 13 percent to 25 percent of investments—exposing them to indirect risk. That is, when one bank’s balance sheet deteriorates, other institutions that hold its debt also suffer. This was a primary mechanism leading to collapse of firms during the 2007-2008 financial crisis.

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To determine the impact of this interconnection, the researchers conducted a ‘stress-test’ of the 50 largest European banks, modeling what would happen if part or all of the value of a bank’s investments in the fossil fuel and utilities sectors were wiped out.

Overall, the top 20 most affected banks could lose between 8 percent and 30 percent of their total capital in the worst-case scenario. Some banks would suffer little to no direct loss, but would be substantially affected by indirect losses stemming from their investments in other financial institutions.

Exposures to climate-policy-relevant sectors of aggregate financial actors worldwide

The study highlights a need for better data on climate-related financial exposures of banks and other financial institutions. Although none of the top European banks are likely to default solely due to loans in the fossil-fuel and utilities sectors, loans in transport, manufacturing, and housing add up to a much more substantial portion of banks’ capital. But the available data do not allow these economic sectors to be evaluated in a comprehensive way.

Even so, the researchers say, the results suggest that if financial firms cannot anticipate policy changes, this will result in economic shocks when fossil-fuel investments abruptly lose value. Early and orderly rollout of policies to control carbon emissions and limit global climate change will facilitate financial gains from investments in renewables and help the financial system transition to a green economy.

Source: Battiston S et al.A climate stress-test of the financial system.” Nature Climate Change2017.
Explore interactive results from the stress test here.
Image: Mark Bonica via Flickr.

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