How climate change threatens global financial stability

Since 2008, when the global financial crisis nearly brought down the world economy, financial reform has been among the top items on policymakers’ agendas. But, as leaders move from fixing the problems of the past to positioning the financial system for the future, they must also grapple with new threats to its stability, particularly those stemming from climate change.

That is why a growing number of governments, regulators, standard-setters, and market actors are starting to incorporate rules concerning sustainability into the financial system. In Brazil, the central bank views the integration of environmental and social factors into risk management as a way to strengthen resilience. And in countries like Singapore and South Africa, companies listed on the stock market are obligated to disclose their environmental and social performance, a requirement that investors and regulators increasingly view as essential to the efficient functioning of financial markets.

Initiatives like these might once have been regarded as part of a peripheral “green” niche. Today, they are considered central to the operation of the financial system. In Bangladesh, the central bank’s efforts to support economic development include low-cost refinancing for banks lending to projects that meet goals for renewables, energy efficiency, or waste management. In the United Kingdom, the Bank of England is currently evaluating the implications of climate change for the insurance sector as part of its core mandate to oversee the safety and soundness of financial institutions.

In China, annual investment in green industry could reach $320 billion in the next five years, with the government able to provide only 10-15% of the total. In order to prevent a funding shortfall, the People’s Bank of China has recently produced a report with the United Nations Environment Programme (UNEP) setting out a comprehensive set of recommendations for establishing China’s “green financial system.”

In India, the Federation of Indian Chambers of Commerce and Industry has established a new “green bond” working group to explore how the country’s debt markets can respond to the challenge of financing smart infrastructure. And recent regulatory changes hold out considerable potential for listed investment trusts to deploy capital for clean energy.

So far, such measures affect only a small fraction of the $305 trillion in assets held by banks, investors, financial institutions, and individuals in the global financial system. But they are set to be applied more broadly as financiers and regulators alike recognize the full consequences of environmental dislocation.

Those consequences already are severe. In 116 of 140 countries assessed by UNEP, the stock of natural capital that underpins value creation is in decline. The human and economic costs of continued high-carbon growth include severe health impacts, growing disruption to infrastructure, and water and food security, as well as increasing market volatility, most notably in developing countries. This damage will become worse, with risks becoming unmanageable if emissions of greenhouse gases are not reduced to net zero levels between 2055 and 2070.

As the threat from climate change becomes more evident, financing the response to its impact will become increasingly important. Developed countries have committed to mobilize $100 billion in annual financial flows to developing countries by 2020, but much more is needed.

Above all, it is essential to place the financing challenge posed by climate change within the broader context of the green economy and sustainable development. The task for those charged with governing the financial system is to enable the orderly transition from high- to low-carbon investments and from vulnerable to resilient assets. According to the New Climate Economy initiative, $89 trillion will be spent on global infrastructure investment by 2030 – with an additional $4.1 trillion needed to make it low-carbon and resilient.

To mobilize the required capital, policymakers will need to harness the power of the financial system. The scope of risk management will need to be expanded, so that long-term sustainability and risks from climate change are included in prudential rules for banking, insurance, and investment. New “green banks” can help to bring in funding from debt and equity markets. Transparency will have to be improved, through better corporate reporting and enhanced disclosure from financial institutions. And financial professionals’ skills and incentives will have to be retooled and revised to reflect these new priorities.

Promising avenues for international cooperation are now opening up. For example, the G-20 finance ministers and central bank governors have just asked the Financial Stability Board to explore how the financial sector could address climate issues. Actions such as these will not only strengthen climate security; they will also contribute to a more efficient, effective, and resilient financial system.

This article is published in collaboration with Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Naina Lal Kidwai, Chairwoman of HSBC India and Director of HSBC Asia-Pacific, is a member of the international advisory council of the UNEP Inquiry into the Design of a Sustainable Financial System. Nick Robins is Co-Director of the UNEP Inquiry into the Design of a Sustainable Financial System.

Image: Fake euro banknotes are seen in a block of ice. REUTERS/Eric Vidal.