Financial sector faces crunch in grip of climate change
We often consider sectoral effects of climate change. Droughts impede agriculture, floods wipe out transport infrastructure and wildfires raze homes. But perhaps the most significant effect is on the financial sector, the glue that holds the economy together.
This glue, created carefully over a century, can disintegrate quickly as climate change effects ramp up. Mark Carney, former governor of the Bank of Canada and Bank of England, highlighted the deep damage this can do through physical, transitional and long-term challenges.
The physical risks of climate change on the financial sector stem from the rising frequency and severity of natural disasters, which will translate to an increase in defaults globally. Analysis by the European Central Bank shows that the average default probability of the credit portfolios of the 10% of Euro area banks that are most vulnerable to climate change could rise 30% by 2050.
The default ratio could be amplified in SA. The Intergovernmental Panel on Climate Change says Southern African temperatures are rising at twice the global average. And the country’s financial sector has an even deeper layer of vulnerability. When looking at domestic credit to the private sector, or financial resources financial corporations provide the private sector, SA is the highest in Africa and in the top 20 globally, at 129% of GDP.
A rise in defaults can have a profound effect on financial stability. We had a taste of that last year. The national state of disaster for declared drought in March 2020 played a role in the state-owned Land Bank’s sharp rise in nonperforming loans, from 9.6% in 2019 to 19.5% at endSeptember 2020. Liquidity remains a challenge due to compounding climate shocks.
Heightened risk from climate change-related incidences has insurers running for the hills as premiums soar and coverage is withdrawn from high-risk areas. In California after widespread wildfires in 2018, 350,000 residents could not get property and casualty insurance that included fire protection. Premiums rose as much as 300%-500% in recent years, making it unaffordable for many. In Louisiana, hit by repeat hurricanes, most insurance policies do not cover flood damage. Anecdotal evidence suggests SA businesses are even more exposed. In the US data shows 75% of all businesses are underinsured and 40% of small businesses have no insurance. If disaster strikes, many firms lack the financial coverage required to cover costs and repay loans.
The second challenge is transition risks due to the shift from fossil fuels to a lowcarbon economy. Fossil-fuel firms and those that financed them are highly vulnerable to transition risks. The consequences of these risks are felt by the entire economy.
Earlier this year, HSBC, one of the world’s biggest banks and Europe’s secondbiggest fossil fuel financier, announced plans to end all new coal financing after substantial pressure from a coalition of shareholders and institutional investors. This was after the bank lent billions of euros to firms building new coal-fired power plants after the Paris climate agreement was signed. Many of the power plants financed by HSBC are likely to become stranded assets as the world sweeps towards decarbonisation, governments impose carbon taxes, shareholder activism strengthens and regulatory pressures ramp up. This will weigh on banks’ balance sheets and reduce the flow of credit to the real economy. It will also inhibit banks’ ability to meet financing demands by households and firms and negatively affect investment and consumption. SA coal mines, with an average life expectancy of 15 to 35 years, are also at risk as key trading partners consider imposing trade restrictions with highemission countries.
The financial sector has been slow to respond to the need for climate mitigation. Most announcements to halt financing for coal-fired power plants came in the past three years, despite decades of knowledge. Carney highlighted the findings of a pension fund analysis in 2019.
“If you add up the policies of all of the companies out there, they are consistent with warming of 3.7°C to 3.8°C.” That near four-degree rise could translate to a 9m rise in sea levels, which would affect 760-million people.
This means many financial sector assets will be under water. Given physical and transitional risks in the short and medium term, and longterm risk to assets, investing in climate mitigation is far cheaper. It is time for the financial sector to see climate change as one of the biggest threats to financial sustainability, not just a “dogood” transition to which shareholders push them.