Are we headed for an epic climate-related financial meltdown? Not if we do these things…

We have seen a slew of weather-related catastrophes in the United States in recent months. Wildfires, droughts, hurricanes, and floods. Scientists caution that it is hard to draw a direct line between any one weather event and global warming.  But they also say that these kinds of extreme weather episodes are a preview of what is going to become all too common in the years ahead.

An under-discussed problem is that the frequency and severity of extreme weather events threatens to shake our financial system to its core.

Gregg Gelzinis is an Associate Director for Economic Policy at the Center for American Progress.  On the Great Ideas Podcast with Matt Robison, he explained that regulators and financial institutions need to act right now to get ahead of the problem.  And he described how they are starting to do just that.

Listen to the full conversation here:

 This conversation has been condensed and edited.

How big a problem is this going to be?

It could be quite significant. One estimate put the future risk from severe weather events at a cost of $2 trillion a year. That’s roughly the equivalent of a 2008-style financial crisis once every five years. Just fossil fuel assets alone could amount to $20 trillion in losses, versus the 2008 financial crisis which was $1.3 trillion total.

Are we talking about risks that we will see in financial institutions or in the real economy?

Both. We’re talking about significant risks to the real economy that will then roll up to financial institutions. So we could get whacked with a climate-driven physical disaster amplified by a financial disaster. If homes are destroyed in a storm, that real physical asset is the collateral for a financial asset, the mortgage. And so the banks might get hit with a twofer. Not only will the borrower be less likely to repay the mortgage, but also that piece of collateral might be worthless or severely diminished in value. It really is a grease fire in terms of the economic damage.

And what’s worse, it could all happen together in a catastrophic worst case scenario. We could have a series of physical shocks in the form of extreme weather over the course of, say, 18 months.  That could spur regulatory action followed by a transition-related shock and a financial crisis.

Is the financial sector starting to price in climate risk?

We’re starting to see it. There are insurance companies pulling back from markets after a catastrophic event. In some coastal locations in Florida it’s actually tougher to get insurance or sell your home.  We see home values declining along the coast in certain areas. But there’s a long way to go.  93% of institutional investors when surveyed in a recent study said that climate change is not adequately priced into markets.

What can we do to address all of this risk?

By integrating climate risk into how we regulate the financial sector. There are two areas to focus on: capital markets (i.e., how we trade things like stocks and bonds) and financial institutions (i.e., banks).  For capital markets, we need transparency.  Everyone needs to understand the climate risk exposure of investments.  There has to be standardized and comparable data across companies. If a company could lose value because of flood risk or carbon regulation, investors need to know about it.

In terms of regulations for financial institutions, the first thing we can do is apply greater supervision. Bank supervisors can make sure that climate is a key consideration in how they oversee risk management. Stress testing is the second thing.  Just like after 2008 financial crisis, we should test to see how bank balance sheets would fare in a severely adverse climate scenario.

Another thing is capital requirements. How much loss can a bank take? We need to make sure they have the resources to absorb more if things go bad. Regulators should require banks to increase their capacity to handle those losses. Finally, I’d like to see activity-based restrictions. There may be some really climate-risky activities that we eventually want to say to banks, you just can’t engage in those activities any longer because they’re simply too risky.

How much are banks going to resist these changes?

The good news is that this is already a bipartisan issue to a degree at the financial regulatory agencies. Even President Trump’s appointed financial regulators acknowledged that climate change poses risk to individual institutions and  the stability of the entire financial system.  It’s also good news that the biggest banks have actually announced quite a few voluntary commitments over the past year or two.  That includes establishing new policies for carbon-intensive lending and putting a dollar figure on “green finance” that they’re going to commit to over the next several years. They’ve all committed to get to net zero by 2050. It is true that they have pushed back on some of the more rigorous interventions that I outlined.  But I think over time it’s possible that they will soften their stance somewhat.

Could the financial services sector even lead us in the right direction and mitigate some of these climate risks?

Absolutely. There are incredible opportunities for the financial system and really for our economy as a whole when it comes to the transition to net zero. So I think financial institutions will increasingly look to take advantage of those opportunities to do what they want to do, which is make money.  Also, financial institutions don’t exactly have undying love for fossil fuels.  They will shift as opportunities elsewhere in our economy present themselves.

We share edited excerpts from the Great Ideas podcast every week that explain how policies work and present innovative solutions for problems. Please subscribe, and to hear more about how to manage the risk of climate-related financial catastrophe, check out the full episode on Apple, Spotify, Google, Anchor, Breaker, Pocket, RadioPublic, or Stitcher

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