Climate change threatens to cause the next economic mega-shock

The stark disconnect between climate science and financial market sentiment will eventually end. It looks increasingly likely to be a sudden and painful adjustment.

Expert comment Published 20 July 2023 Updated 25 July 2023 3 minute READ

The likely trajectory of climate change, given current global performance on emissions reduction, has been spelled out repeatedly. Extreme weather events, like the unprecedented heatwaves suffered by Southern Europe, the US and China this week, will become even more frequent and destructive as a result.

The severe economic and financial consequences of climate change are clear, particularly given the enormous shortfall to date in spending on adapting to what is to come.

The severe economic and financial consequences of climate change are also clear, particularly given the enormous shortfall to date in spending on adapting to what is to come.

Crop failure will lead to much higher food prices and millions of economic refugees. Prime real estate and agricultural land in coastal areas will be abandoned in the face of repeated flooding.

Carbon-dependent industries will face sudden closure as public opinion and government regulation shifts, while other sectors will suffer potentially devastating supply chain breakdowns. New diseases and disease patterns will impose heavy costs on public budgets.

It can no longer be argued that these are highly uncertain or distant prospects. In many cases they are now inevitable, even if mitigation policies accelerate radically. 

And yet, there is very little evidence today of asset prices adjusting to reflect these developments. 

And yet, there is very little evidence today of asset prices adjusting to reflect these developments. 

Some researchers have found higher risk premia in the sovereign debt of developing countries with greater vulnerability to climate change. There is also some evidence of lower returns (reflecting lower risk) on the equity of firms which are less exposed to climate change.

But overall the markets do not seem to be particularly concerned. Conversations with prominent advisers in major financial institutions partly explain this.

Why financial markets do not yet reflect climate risk

One fairly common view in the US and Europe is that rapid technological development will solve the problem – and that the markets’ lack of concern itself confirms the value of this position. 

But this view assumes that markets are rational, accumulating and then reflecting all available information. It also assumes away the enormous challenges – both technical and financial –  in diffusing new technologies rapidly around the world. 

Another view is that climate change is inherently complex and uncertain, as are its macroeconomic effects, and while these could become important in the medium or long-term, inflation and rising public debt are higher priorities today. 

This opinion looks much harder to sustain in the face of current extreme weather events with major economic impacts.

Institutional features in financial markets may also play a role.

It is not uncommon for the prices of currencies, equities or debt to under- or overshoot.

There may be a strong consensus that a large price adjustment is justified by the fundamentals. But since no one knows exactly when it will happen, taking a position on it is risky for individual investors.

As a result, the mismatch between the asset price and an objective assessment of underlying value persists, or even gets worse.

Other kinds of ‘sub-optimisation’ may also play a role as hydrocarbon-based industries use political lobbying to delay or weaken regulatory measures that threaten their legacy businesses, even when there is an overwhelming economic rationale for the change.

There is also strong evidence of ‘path dependency’ in the behaviour of investors, who stick to locations, counterparts and technologies they are familiar with, even though alternatives may be far more profitable.

It is striking that these factors are still so significant despite all the effort that has gone into sensitizing financial institutions to the need to understand, measure and be transparent about the climate risk in their portfolios since Mark Carney’s 2015 speech highlighting the issue.

Whatever the reasons for the markets’ current equanimity on climate risks, a sharp adjustment looks increasingly probable.

Whatever the reasons for the markets’ current equanimity on climate risks, a sharp adjustment looks increasingly probable. The longer it is delayed, the sharper it is likely to be – and the more potential triggers emerge. 

Triggers for a climate economic and financial shock

One possibility is that financial regulators and/or independent analysts will start looking more intensively and critically at the climate risk in major financial institutions’ portfolios, applying stress tests based on new, more extreme, but also realistic climate scenarios and ‘non-equilibrium’ economic forecasting models. 

This could be accompanied by detailed – and much more pessimistic – independent assessments of risks to real estate in coastal metro areas, such as Miami, Shanghai and Amsterdam, or regions subject to extreme heat. 

This may cause an increasing number of financial markets to close, or partially close, as individual institutions conclude they can no longer accept climate risks in their core business. The recent withdrawal of two major insurers from the California residential market is an example. 

As the global financial crisis showed, such developments can have ripple effects, where the closure of one market quickly forces another related market to close.

It is also possible that climate risk will become a major factor limiting – and potentially closing – developing countries’ access to international financial markets. As the global financial crisis showed, such developments can have ripple effects, where the closure of one market quickly forces another related market to close.

Another possibility is that, faced with the kind of extreme weather experienced this summer, public opinion in several key countries will start demanding much more radical action from governments, short circuiting technical and administrative processes, and resulting in the kind of extraordinary measures seen during the pandemic. 

This might involve the closure of entire industries, or the emergency imposition of tariff barriers against high-carbon imports.

There could also be political developments which trigger a broader and much more pessimistic reassessment of climate risk.

For example, if the Bridgetown Initiative and Summit for a New Global Financing Pact fail to shift positions in the G20, markets may conclude there is no realistic chance of closing the massive climate finance gap (estimated at $3tn per year) required to deliver net zero.  

Alternatively, if former President Trump wins re-election in the US and immediately reverses the Biden administration’s climate policies, markets may react to much higher global temperature scenarios.

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It is foolhardy to try and predict precisely when a scenario of this kind will take effect. But financial markets embed developments several years ahead in today’s asset prices, and they do so more decisively when uncertainty is reduced.

Therefore, such a shock looks a realistic possibility at any time over the next five years.

It could be argued that this is precisely the kind of crisis that could trigger the step change in public policy and private behaviours needed to avert a climate disaster

It could be argued that this is precisely the kind of crisis that could trigger the step change in public policy and private behaviours needed to avert a climate disaster.

But while this may be true, it would be far preferable if economic policymakers across all parts of government recognized that they cannot afford to put this threat to one side, even when faced with the parallel challenges of high inflation, rising debt and low productivity.

The climate threat has to be tackled simultaneously with these other challenges. Indeed if one is forced to choose, the climate threat should be the economic policy priority.