Since anthropogenic climate change was first recognised, it has posed a clear long-term threat to the financial system, and central banks have taken notice. Previous governors of the Bank of England have expressed concern about the crisis, while the ECB is currently aiming to assemble a climate change action plan. In the US, the Commodity Futures Trading Commission published a report on the threat posed by climate change to economic stability. Whether or not the government takes sufficient action, the financial system will certainly have to change to deal with the climate crisis, either to adapt to new green measures or to cut their losses from crisis-related natural disasters.
Assuming the world takes substantial measures to reduce emissions, the financial system is likely to face substantial challenges. At present, investment banks and hedge funds are heavily financing the fossil fuel industry, seeing it as a safe bet. Yet if there are any guaranteed losers in the case of major green policy measures, it is the fossil fuel industry. Despite some efforts at diversification, the energy conglomerates involved in this industry are still so firmly rooted in hydrocarbons that any fast-acting regulatory measures would throw them into disarray. This, in turn, would provoke turmoil among traders who had previously considered them reliable investments, radically upsetting the stock market.
Such a course of action is unlikely. Thus far, the UN Climate Change Conferences have produced gentle, non-binding targets, with signatories imposing only limited internal regulations. Although the upcoming COP26 conference in Glasgow should see countries impose stronger, more ambitious targets, the absence of the Presidents of Russia and China suggests that the overall impact will be measured. As such, a mass panic among fossil fuel investors is highly improbable, and the markets will have plenty of time to rethink their investments, hopefully gearing them more towards renewable energy in the future. Of course, some will undoubtedly stay the course - but there should be enough divestment to limit the upset caused by future policy shifts encouraging clean power sources.
Besides this, the growing threat of the climate crisis has already started to mould the financial system. Venture capital is flowing into green energy; as fossil fuel energy loses its cost-effectiveness advantage, it is likely this flow will only continue. Though the previous wave of green investment ended in a burst bubble, the current generation of technology is a lot more reliable and seems far more likely to follow through on its impressive promise. The last generation had to deal with the emergence of fracking, but that industry has since declined substantially, so eco-friendly investors do not have nearly as much to worry about from the fossil fuel world. All in all, it seems that this response to the climate crisis will have a lasting impact on the shape of the financial system.
Moreover, this new wave of investment has cast its net across a much broader range of technologies. The emphasis is not just on power itself, but also on new aviation fuels, electric vehicles, low-carbon building materials, eco-friendly foodstuffs and any other niche that might fit a green alternative. These firms are smaller, with more realistic promises, but great long-term potential. Some will undoubtedly fail, but their sheer number provides ample opportunity for success, and in the long run many of these firms can be expected to rise to a position of prominence. As they do so, traditional polluting industries will likely see a sharp fall in their share prices, ultimately helping to reshape the financial system further.
As aforementioned, the actual process of fighting climate change will likely continue to be slow and relatively timid. Unfortunately, this means that, unfortunately, the climate crisis’ impacts on the world will only get worse for the foreseeable future, and as they do, so too will the financial system be impacted. The most immediate example of this is natural disasters, which have been steadily increasing in impact as the Earth’s atmosphere continues to warm. This summer alone, Europe saw severe wildfires in Germany and Greece, while similar catastrophes struck the US, Russia, Australia and elsewhere in recent years. The Financial Stability Board estimates that economic losses from weather-related natural disasters grew from about $214 billion in the 1980s to over $1.6 trillion in the last decade, and they will only grow as the Earth’s temperature increases.
At present, these losses are mostly soaked up by insurance companies. Insurers survive, however, by passing those extra costs onto the consumer, which could have severe consequences in the long-run. As insurance premiums rise, businesses in disaster-prone regions will have to choose between surrendering an increasing portion of their revenues, or taking greater financial risks. In turn, these regions can expect a decline in investment, as banks and hedge funds look to find safer places to store their capital. In the long-run, the financial system will have to adapt to falling returns on investment, and change its expectations accordingly.
Outside the immediate monetary losses of natural disasters, there are other severe threats to consider. For example, as climate change worsens, previously arable land might be rendered useless by desertification. Not only would this have a direct economic impact, but it could also result in severe famine, which would radically destabilise afflicted nations. Food scarcity would thus undermine associated industries, especially shipping, as former agricultural exporters instead prioritise their own population. Alternatively, faced with mass starvation and unrest, governments might choose to expropriate any remaining food sources under foreign ownership. For financial institutions, this fundamental uncertainty could be catastrophic.
At the same time, these catastrophes come at an enormous human cost. In those impoverished countries which cannot afford to mitigate the effects of climate change, whether in the form of natural disasters or in crop failures, refugee crises are almost certain. As mass migration occurs, local industries and utilities would be pushed to breaking point, and conflicts over land, resources and people flare up substantially. This sort of instability would make conventional business more risky, and the only investments positively affected are those relating to war. For the financial system to operate in these areas, it needs to mould itself into a much more responsive machine, accustomed to rapidly cutting its losses when human tragedy disrupts a risky venture.
Ultimately, there are two possible ways in which the climate crisis might transform the financial system. If major international cooperation occurs in order to limit climate change and mitigate its worst effects, the financial system will have to adapt, with capital withdrawing en masse from fossil fuels and polluting industries. At the same time, new opportunities will present themselves in renewable energies and green technologies. If these prove successful, the overall shape of the financial system might not be that different from how it is today, as it essentially tries to replicate the existing arrangements while reducing emissions and consumption of natural resources.
The alternative is substantially more transformative, and not in a good way. If the climate crisis is not effectively handled, the financial system may be upset radically by a changing world. In such a scenario, it would have to become leaner and more agile, cutting losses rapidly in areas hit by climate-related damage. Simultaneously, lenders and investors would have to be willing to capitalise on the few opportunities that appeared, whether through exploitation of altered environments like melted Siberian tundra, or through increasingly predatory activity in less fortunate parts of the globe. Still, if such instability became too widespread, the modern financial system might not be able to survive – at least not in a form recognisable to anyone today.
In the end, it is hard to tell exactly how the financial system will react to the climate crisis. The most likely outcome seems to be somewhere between the two extremes. It will have to become much more reactive, divesting from fossil fuels while remaining open to whatever opportunities present themselves. At any rate, there is no question as to whether the financial system will adapt – the real question is how much, how fast, and whether it will be enough.
A Smith, '2018's Billion Dollar Disasters in Context', 7th February 2019, Climate.gov.
'Could climate change trigger a financial crisis?', 4th September 2021, The Economist.
'Banks tested on climate crisis risks', 8th June 2021, BBC News.
A Benveniste, 'The climate crisis is an 'emerging threat' to financial stability, US regulators say', 21st October 2021, CNN Business.