In recent years regulators have begun warning about the threat that climate change poses to the stability of the financial system. Following its strategy review in July, the European Central Bank (ecb) will assemble a “climate change action plan”. Mark Carney, the former governor of the Bank of England, warned of financial risks from climate change as long ago as 2015. In America the Commodity Futures Trading Commission last year published a 200-page report beginning “Climate change poses a major risk to the stability of the US financial system.” […] Just how damaging does climate risk stand to be, though? Early stress tests by central banks and disclosures of companies are starting to shed light on the question. For the most part, the evidence that it could bring down the financial system is underwhelming. But a lot hangs on whether governments set out a clear path for reducing emissions, such as through carbon taxes and energy-efficiency standards, giving banks enough time to prepare.
Climate change can affect the financial system in three ways. The first is through what regulators describe as “transition risks”. These are most likely to arise if governments pursue tougher climate policies. If they do, the economy restructures: capital moves away from dirty sectors and towards cleaner ones. Companies in polluting industries may default on loans or bonds; their share prices may collapse.
The second channel is financial firms’ exposure to the hazards of rising temperatures. Attributing individual natural disasters to climate change is tricky, but the Financial Stability Board, a group of regulators, estimates that global economic losses resulting from weather-related catastrophes went from $214bn in the 1980s, in 2019 prices, to $1.62trn in the 2010s, roughly trebling as a share of global gdp. These losses are often borne by insurers (though over time the costs should be passed on to customers through higher premiums).
The financial system could also be exposed to any wider economic damage caused by climate change, say if it triggered swings in asset prices. This third channel is harder to quantify. Academic estimates of the effect of 3°C of warming (relative to pre-industrial temperatures) veer from financial losses of around 2% to 25% of world gdp, according to the Network for Greening the Financial System, a group of supervisors. Even the gloomiest estimate might prove too rosy if climate change triggers conflicts or mass migrations. […]