Climate risk and systemic financial risk
How climate risks become problems and opportunities for our financial system
Over the past year, international and domestic financial authorities and regulators have become increasingly concerned with the risks that climate change poses to our financial system. Lael Brainard and Janet Yellen have both been vocal about the issue, as has the Bank of International Settlements. In this post, I’ll outline some of the key reasons for concern, and outline some of the opportunities this situation presents.
The first and most obvious area where climate risk spills over into the financial system is with our insurance markets. As someone who knows a bit too much about P&C insurance, I can tell you that the state of the weather and the frequency and severity of natural disasters is perhaps the most important input into a P&C (re)insurer’s financial outcomes. P&C (re)insurers can of course adjust their natural disaster prediction models for the expected impacts of climate change, and accordingly increase premiums and adjust financial guidance, but the challenge here is that the potential distribution of climate-related outcomes is wide and unpredictable. It is in an insurer’s interest to model for the most extreme outcomes, but this might make wide swaths of the world uninsurable. There’s a commercial opportunity here for businesses and service providers to create insurance risk models that strike the balance between accounting for climate risk and still facilitating commercially viable insurance in high-risk regions.
In a similar vein, lenders and investors face climate-related risk when it comes to potential rapid changes in value of collateral/investment holdings. It’s not hard to imagine a reality where a catastrophic California wildfire or a nasty New York hurricane completely wipes out a real estate investor’s portfolio and decimates various lender loan books in the process. There’s real value in solutions that can help account for this risk in a loan or investment portfolio, as climate-related risk is not a risk vector that is traditionally deeply researched in loan or investment due diligence.
There are also “transition risks” associated with climate change mitigation. Many businesses, individuals, and investors rely on fossil fuel-related income as the bedrock of their existence. A rapid decline in the value of carbon-related assets due to a shift in energy mix could cause market and economic instability. Insurance products that help protect against downside risk here, as well as investment vehicles and businesses that smoothly facilitate a transition from carbon-related income to clean energy-related income can help smooth out this “transition risk.”
All of these risks come together to produce “systemic” climate risk for the financial system. The promise and peril of our financial system is that insurance companies, banks, financial markets, and businesses are all tightly woven together through countless connections. The failure of a major (re)insurer or real estate investor could trigger systemic issues across the American and global economy. Regulators and businesses should seize the opportunity to get ahead of these risks and ensure the financial system is a source of climate resiliency, rather than climate risk.
PS: I’m just starting to learn about climate and financial risk, and would love to interview any founders working on related issues for the Fintech Explorer!