Climate change is driving a financial crisis – here's what needs to change

COVID-19 and the escalating climate emergency have driven home one key message: disaster risk is systemic financial risk.

The past 22 months gave us more than a glimpse on what “business as usual” could mean in an increasingly unpredictable risk landscape. As of September 2021, the pandemic has caused over 5 million deaths, $12 trillion global GDP loss and record debt in most developing countries. Recovery prospects depend on where you are. At the same time, we have experienced a suite of “never-before” disaster events, raging conflict, trade wars, displacement and humanitarian crises, with climate change predicted to reduce global economic output by 18% by 2050.

In reaction, calls for systemic change towards a more resilient and sustainable future echo around the globe.

Yet, despite record human and economic losses, stock markets rallied and global trade flows jumped back to pre-pandemic levels. Improving economic prospects in the developed world prompt some to praise the resilience of our financial system and raise temptation to go back to business as usual.

But is the system truly fit for the future? And if not, what can be done about it?

A critical issue is that disaster risk and related costs are not reflected in financial modelling or analysis or commodity or asset prices, nor do they appear on the balance sheet or affect companies’ profitability and valuations. Therefore, unsustainable companies have a lower cost of capital than their more sustainable peers, allowing – or even rewarding – them to misallocate capital towards risk creation rather than risk reduction or prevention. Moreover, the economic costs of a disaster are rarely born by those who caused it but left to governments, communities and the most vulnerable. As a result, markets operate “risk-blind” when it comes to high-impact shocks.

To avoid financial havoc when the world is hit by the next mega disaster(s), this market failure must urgently be addressed by governments who bear primary responsibility for risk reduction, sustainable development and the overall wellbeing of people and communities.

The race to net zero is rapidly accelerating, with strong commitments issued daily by country, business and finance leaders. “ESG” (Environmental, Social, Governance) and “TCFD” (Task Force on Climate-Related Financial Disclosures) are buzz words in financial circles. This is very welcome.

Yet, with climate change no longer a future threat but today’s reality, and expected to impact our lives and livelihoods for years to come in even the best-possible mitigation scenario, we need equally accelerated efforts on adaptation and, importantly, multi-hazard risk reduction. In a world threatened by more than 300 natural and man-made hazards and non-linear, interconnected risks, making risk-informed trade-offs to ensure investment decisions do not (unbeknownst) create new or augment other existing threats will be critical for our very survival.

Clearly, such a challenge can only be overcome through close cooperation between different stakeholders, and the financial sector must be part of this effort. This is not just a human and economic imperative, says Steve Waygood, but also part of investors’ fiduciary duty to keep markets working well for shareholders and clients.

Luckily, we don’t need to start from scratch. With the Sustainable Development Goals (SDGs), Paris Agreement, Addis Ababa Action Agenda and Sendai Framework for Disaster Risk Reduction (the only 2030 agreement that expressively mentions the role of the financial sector and regulators), we have the global policy commitments to shift from risk-blind to risk-informed investment. We have also seen increasing action on building resilience, particularly in the run up to COP26.

However, we need to raise the ambition and put comprehensive risk reduction at the heart of financial sector decision-making. Risk-informed investment will be rewarded, as prevention pays. UNDRR estimated $6 billion in prevention can generate economic benefits of $360 billion. Success depends on three critical elements:

1. Broadening the horizon from investing in sustainability and climate resilience, to incorporating sustainability and resilience into investment.

Meeting the SDGs in five priority areas by 2030 will require additional annual spending of $528 billion for low- and lower middle-income and $2.1 trillion for emerging countries. But in 2020 alone, the world's total market capitalization was estimated at $56,656,146 million.

Thus, for risk-blind markets not jeopardizing the SDGs, we must go beyond green, sustainable or impact-focused financial products, to making all investment risk-informed and thus sustainable and resilient. This could be done through the development of sustainability and resilience key performance indicators aligned with the Sendai Framework and applied across all public or private investment.

2. Enhancing our understanding of and capacity to address systemic disaster risks including recognizing and embracing interlinkages and trade-offs.

The new EU regulations in support of a green and sustainable future attempt this in including the “do-no-harm” principle. Building on this, natural and man-made hazards, their interconnections and systemic impact should be incorporated into ESG and risk disclosure frameworks. Existing disaster loss databases, risk registries and statistics, stress tests and initial work to integrate climate and financial risk modelling can support this effort.

3. To put risk reduction at the heart of investment decisions and unleash the power of public and private finance and investment towards resilience and sustainability, governments should change the profit motive by ensuring investors and other companies pay the full cost of risk creation.

This requires the internalization of disaster risk and costs into companies’ profit and loss statements, recognizing the double materiality of risks –risks companies face and risks they create. Sustainability risk disclosure, rating, standard and accounting requirements, carbon pricing schemes, tax incentives for green products or reserve requirements, feed-in tariffs and production tax credits introduced after 2008 financial crises and other policy, fiscal and market mechanisms should be expanded or adapted to cover broader risk reduction.

Times of crises are a shock to any system. However, they also come with an opportunity to rethink, learn, adapt and change.

As the UN Secretary-General highlighted this month, with the world slowly emerging out of the pandemic, we must reconsider how we deal with increasingly systemic climate and disaster risk, looking at resilience from long-term, multi-hazard and prevention-focused angles. This can only be done with strong leadership at the macro-level from those mandated to do so. Governments gathering at COP26 have an unprecedented opportunity to take decisive action to make risk-informed investment a market incentive towards and within a sustainable world. Let’s not miss it.