The Governor of the Bank of England Mark Carney recently delivered a well-received speech in London, United Kingdom, to a community of financial sector representatives emphasizing the impact that climate change could have on financial sector stability.
The impact could be threefold. The first type of risk is direct — the increasing frequency of extreme weather events such as floods could have impacts on the insurance sector in particular, which will have to pay for the damage to insured property caused by these events. A second type of risk will be the liability risk for insurance firms from claims made by parties suffering damage due to climate change caused by others. If such claims are successful, they could be passed to insurance firms that would then have to pay.
The third risk is transition risk, which could emerge as a result of the transition to a lower-carbon economy, which will be necessary to avoid the major impacts of climate change. If such a transition occurs, the investments in the fossil fuel sector would become stranded assets — investments made based on the assumption that all fossil fuel resources can be sold and used. If only some of the fossil resources can be sold — the Intergovernmental Panel on Climate Change (IPCC) states about 35 percent of the resources — it would mean a significant decrease in the income of the fossil fuel industry (Field et al. 2014). The consequence would be decreasing share prices and losses for investors. The transition risk could also affect investments in other energy intensive sectors such as the chemical industry, metals and mining, to name just a few. These industries could be affected by carbon pricing, and higher allowance costs for carbon emissions could create risks for investors.
The financial sector, however, is significantly invested in sectors that are affected by the transition to a lower-carbon economy and, consequently, could suffer losses from these investments in so-called stranded assets. Climate change does not only create environmental damages but financial risks as well. A major transition in industries could have significant effects on investment portfolios and on the stability of the financial sector as a whole. The fact that the Financial Stability Board has already discussed the issue is an indication of the importance of climate change in the financial sector.
The integration of climate finance into the G20’s agenda is therefore an important first step to manage financial stability risks that could occur due to climate change. The question, however, is what mechanisms are available to address this type of risk?
First, sustainability and environmental regulations such as those on emissions, waste, contaminated soil and others, are in place in many countries; however, enforcement is sometimes weak. Environmental regulations should be strengthened and mechanisms should be implemented to guarantee their enforcement. Strong environmental regulations help the financial industry to operate without major impacts from the effects of unexpected risks. In turn, the management of environmental risks can be integrated into general risk management processes.
Second, regulations should focus directly on the financial sector. So far, only a few countries and central banks have integrated sustainability into their financial regulations. It would make sense, however, to implement financial regulations and incentives to channel financial sector capital into investments and loans that are both positive for the environment and manageable with regard to their financial risks. The G20 would have to look into the practices of its members to understand the mechanisms and consequences of such financial sector sustainability regulations.
Third, voluntary codes of conduct have contributed to a move in a more sustainable direction in some cases. For instance, the Forest Stewardship Council is often perceived as having created a change in corporate sustainability in businesses that deal with forestry products. In the financial sector, there are a number of codes of conduct, such as the Equator Principles, the UN Environment Programme Finance Initiative and the UN Principles for Responsible Investment, that have been adopted by more than one thousand financial institutions. What is needed, however, is research and discussion on whether these voluntary “soft laws” create a change in the industry and have a positive impact on both sustainable development and financial sector stability.
The connection between the financial sector and sustainable development is complex and of an indirect nature. Although it is undisputed that the sector can contribute to sustainable development, the question remains: how can we manage the interaction between major environmental challenges such as climate change and financial sector stability? This task should not be exclusively located in administrative and political institutions that focus on the environment. The incorporation of climate finance into the G20 agenda is only the first step to manage financial sector stability and climate change in an integrative way. The next step should be the development of policies and guidelines that help to manage climate change and financial risk in a prudential way.
Field, C. B., V. R. Barros, K. Mach, and M. Mastrandrea. 2014. Climate Change 2014: Impacts, Adaptation, and Vulnerability. London: Cambridge University Press. www.ipcc.ch/report/ar5/wg2/.