Climate Change and Financial Stability. How Climate Change affects Financial Stability


Academic Paper, 2021

16 Pages, Grade: 1,3


Excerpt

Table of Contents

Abstract

Table of Contents

List of Figures

List of Abbreviations

1 Introduction

2 Key Terms
2.1 Climate Changer
2.2 Financial Stability

3 Climate Change as a source of financial instability

4 Scenario Analysis
4.1 Potential Impact on equity prices
4.2 Inaccuracy of estimated impacts on equity prices

5 Solutions
5.1 What can Central Banks do to provide financial stability
5.2 What can Governments do to provide financial stability

6 Summary and Outlook

List of References

List of Figures

Figure 1. Global economic losses from weather catastrophes 2000-2019

List of Abbreviations

ECB = European Central Bank

IMF = International Monetary Fund

IPCC = Intergovernmental Panel of Climate Change

NGFS = Network for greening the financial system

WMO = World Meteorological Association

Abstract

This paper addresses the risks posed by climate change in terms of financial instability. The objective is to derive counteractions and recommendations for policymakers and central banks. The derivation of possible appropriate measures on the part of public institutions clarifies that, above all, a high insurance rate and financial reserves are important to buffer the impact of climate-related disasters. It will also be suggested that central banks might consider targeting their monetary policy instruments to environmental sustainability goals. The analysis of the topic furthermore highlighted the fact that investors have so far paid little attention to the risks and costs arising from climate change. Therefore, it should be within the mandate of public authorities and companies to disclose residents and investors expected climate change related risks.

Key Words

Climate change, Climate risk, Financial stability, Financial risk, Central bank, Government

1 Introduction

A study conducted by Munich Reinsurance Company Munich Re found that the number of climate hazards has more than tripled since 1980 (Munich Re, 2018). Experts assume that this trend could intensify due to the current global warming caused by human-made greenhouse gases. “Overall, worldwide economic costs from natural disasters have exceeded the 30-year average of USD 140 billion per annum in 7 of the last 10 years.” (Network for Greening the Financial System [NGFS], 2019, p. 13). Besides the tragic consequences of natural disasters, environmental damage and many more, people have to face financial hurdles due to more frequent climate catastrophes. This potential threat also endangers financial stability and could lead to an uncontrollable downward spiral (International Momentary Fund [IMF], 2020).

The Paris Agreement, signed in 2016, aims to limit global warming to well below 2°C, thereby reducing climate change related risks. However, the transition to an economy that produces way fewer emissions only comes at huge costs either. The Intergovernmental Panel of Climate Change (IPCC) calculated the total costs of limiting global warming to 2°C at 1-4% of global consumption by 2030 (Intergovernmental Panel of Climate Change [IPCC], 2018).

It becomes clear that society is already in the middle of a dilemma that it has created by itself. Moreover, the financial markets have so far ignored the whole issue, worsening the risk of financial shocks.

As climate change threatens financial stability, appropriate countermeasures need to be discussed. This is the purpose of the following paper. Before that, the terms climate change and financial stability will be defined. In addition, a closer look at how climate change affects financial stability is mandatory. It is also becoming clear that the financial markets have hardly considered the potential risks of climate change, as expected from standard asset pricing theory (IMF, 2020). After the measures taken by governments and central banks have finally been discussed, the research paper is concluded with the last chapter namely summary and outlook.

2 Key Terms

This chapter provides a definition of the basic terms Climate Change and Financial Stability. The explanation of the term Climate Change is enhanced by a short description of the origin and possible effects. Regarding Financial Stability, a definition of the term and the assurance of the same will be analysed.

2.1 Climate Change

In general, climate is the average state of the atmosphere at a particular location or in a particular area over an extended period of time. As a time span, the World Meteorological Organization (WMO) recommends at least 30 years, but observations over longer periods such as centuries and millennia are also common in climate research. In contrast, weather represents the atmosphere's current physical state at a given location at a time span of maximum few days. The climate is characterized by statistical properties of the atmosphere, such as mean values, frequencies, persistence behaviour and extreme values of meteorological quantities (Umwelt Bundesamt, 2013).

Since quite some time, a change in the worldwide climate is determined and discussed. Empirical data show that the global mean temperature started to increase about a century ago. The global mean ground-level air temperature increased, mountain glaciers and snow cover decreased on average worldwide, and extreme events such as heavy precipitation and heat waves became more frequent (Umwelt Bundesamt, 2016). It is argued that humans cause this most recent climate change, respectively, the industrialization. Burning fossil fuels (such as coal and petroleum) and large-scale deforestation accumulate carbon dioxide (CO2) in the atmosphere. Additionally, agriculture and animal farming produce gases such as methane and nitrous oxide. An accumulation of these gases in the atmosphere tends to warm the lower layers of the air. This process is commonly referred to as the greenhouse effect. (Umwelt Bundesamt, 2016).

The "anthropogenic greenhouse effect" (Umwelt Bundesamt, 2013a, n.p.) has far-reaching consequences. The mean global temperature is primarily expected to increase between 1.8 and 4.0 degrees Celsius by 2100 (IPCC, 2007), depending on the amount of greenhouse gases produced. This change in temperature is more rapid than any natural temperature change observed over the last 10,000 years (IPCC, 2007). As a result of warmer temperatures, glaciers will melt, and sea levels will rise. The calculations on the actual rise of the sea level vary from 20 cm up to 1.6 meters. Additionally, the rise of the temperature and air humidity already increased the frequency of extreme weather events. In many regions, extreme precipitation, floods, hurricanes, and a higher likelihood of droughts and wildfires have been observed. According to the Munich Reinsurance Company Munich Re, the number of climate hazards has tripled since 1980 (Munich Re, 2018).

The changes have dramatic consequences on human lives but also on economic measures. The analyzation of such dimensions will be part of chapter three.

2.2 Financial Stability

The European Central Bank (ECB) defines financial stability as follows: "Financial stability can be defined as a condition in which the financial system – which comprises financial intermediaries, markets and market infrastructures – is capable of withstanding shocks and the unravelling of financial imbalances." (European Central Bank [ECB], 2020, n.p.)

The financial system is a complex network of interdependencies and interactions between different players. Banks and insurance companies act as intermediaries by supplying money to lend or invest in those who want to borrow money. This means stability is all about keeping up the balance within this network (ECB, 2016). In Europe, the maintenance of this balance is the objective of the ECB. The institution is continuously working to ensure stability in the euro area by means of various instruments. To this end, the ECB monitors current trends and can, if necessary, take appropriate countermeasures through monetary policy and regulate certain specifications (ECB, 2016).

Several factors could disturb the balance of the financial system. Possible threats are, for instance, summarized within the financial stability review of the ECB or the Global Financial Stability Report of the International Monetary Fund (IMF, 2020). In 2020, the ECB report stated a more fragile economy due to the Covid-19 impact, uneven recovery from the Euro countries' pandemic, weaker bank profitability and rising credit risks as potential triggers for financial instability. The IMF report of April 2020 is primarily concerned with the Corona crisis and possible damage caused by climate change. In the following chapter, there will be a closer look at how climate change could endanger financial stability.

3 Climate Change as a source of financial instability

In regard to climate change, there are in summary two factors that will influence financial stability and the economic situation, namely physical risk and transition impact. Physical risk describes the impact of climate change related economical costs and financial losses resulting of extreme weather events (NGFS, 2019). The following figure should serve as an illustration of physical impact: Global economic losses from weather catastrophes 2000-2019 (in billion USD)

Abbildung in dieser Leseprobe nicht enthalten

Source: Own illustration based on Statista (2020)

The illustration shows the economic damage caused by weather catastrophes from 2000-2019. As it can be derived, the biggest damage within this timeline was caused in 2017 totalling losses of USD 462 billion.

On the other hand, transition impact describes the costs of adjusting the industry to reach a carbon dioxide footprint of “net-zero” (NGFS, 2019, p. 12), which is mandatory to limit the progress of climate change. Reducing emissions will have a significant effect on all sectors of the economy. Even though immediate reductions would be necessary to fight climate change, this would eventually trigger harmful revaluations of assets (NGFS, 2019).

In conclusion, both factors impact economic measures, but how exactly do they endanger financial stability?

As the magnitude of damages caused by extreme weather events increases, depending on future emissions, potential losses in human capital and assets, as well as larger disruptions in economic activity, are expected to be much higher than in history (IMF, 2020). The IMF report expresses a general concern that the “financial systems may be unprepared to cope with this potentially large increase in physical risk” (IMF, 2020, p. 86).

The potential damage of climatic hazards varies and can lead to financial disruptions if they hit in regions where the vulnerability is high (IMF, 2020). Besides companies with specialized production plants, also locally distributed service providers would be affected by operational risk. In addition, noticeable write-downs due to the loss of assets or deposited collateral (in case of banks) could quickly lead to a liquidity crisis (IMF, 2020). Besides the actual impact, rising uncertainty about climatic threats could result in a reluctance to invest in a particular region.

Transition risk is dealing with limiting the impact of possible physical impacts by taking counteractions. The Paris Agreement in 2015 states to limit the warming of the global average temperature to 1.5°C. Therefore, a reduction of Greenhouse gases to net zero emissions needs to be reached by 2050. However, the transition to a net-zero economy requires far-reaching changes in energy production, logistics, industrial systems and many more. The Intergovernmental Panel on Climate Change (IPCC, 2018) calculated the costs for necessary adjustments at USD 830 billion annually between 2016 and 2050 (IPCC, 2007). Regarding this calculation, the European Union alone has an investment gap of EUR 180 billion annually, pointing out a necessity to redirect investments towards a greener economy. Furthermore, the IPCC calculated that the total costs of limiting global warming to 2°C would equal 1-4% of global consumption by 2030 (IPCC, 2007). Despite the need for further research on the actual impact, the largely affected energy sector is expected to reveal losses between USD 1 trillion and USD 4 trillion. For the economy in total, losses are estimated to reach up to USD 20 trillion (NGFS, 2019).

Even though these figures indicate an extreme burden, the costs of not reducing greenhouse gases, procrastinating mandatory action, would be comparatively small (NGFS, 2019).

[...]

Excerpt out of 16 pages

Details

Title
Climate Change and Financial Stability. How Climate Change affects Financial Stability
College
University of Applied Sciences Augsburg
Grade
1,3
Author
Year
2021
Pages
16
Catalog Number
V988688
ISBN (eBook)
9783346357007
ISBN (Book)
9783346357014
Language
English
Tags
Climate Change, Financial stability, Klimawandel, Physical Risk, Transition Risk
Quote paper
David Baur (Author), 2021, Climate Change and Financial Stability. How Climate Change affects Financial Stability, Munich, GRIN Verlag, https://www.grin.com/document/988688

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