- The more extreme and frequent weather events get, the higher the financial damage associated on property, but also on other parts of our economy.
- Meanwhile, more and more countries are committing to becoming carbon neutral in the next few decades. Though necessary, this transition is also a risk.
LONDON — Climate change is increasingly influencing investment decisions, but it also poses certain risks to financial stability that are not being taken completely seriously, experts have told CNBC.
People are now much more aware of the issue, even those who have savings invested in carbon intensive companies, Yannis Dafermos, a lecturer at SOAS University of London, told CNBC. He added that as a result "they also realize they might face some financial losses, if they don't do anything."
As a result of the increased climate awareness, "there is now more pressure for instance on institutional investors and pension funds to adjust to the new reality," Dafermos added.
Investments in ESG funds (which put either environmental, social or governance criteria at the heart of their decisions) have picked up in recent years, mainly in the wake of the coronavirus pandemic. Deloitte estimated last year that there could be 200 new ESG funds set up between 2020 and 2023, more than doubling the activity seen in the the previous three years.
But there are issues with ESG as whole, including a lack of transparency on what firms are actually doing in this field and the need for tougher regulation. And at the same time, ESG funds do not solve all the issues that climate change poses for markets.
One area where it's clear that markets are not fully pricing in climate risks is government bonds.
Moritz Kraemer, chief economist at research firm Country Risk, told CNBC's "Squawk Box Europe" last week that the G-7 nations together could see their credit ratings fall by more than three notches over the next 80 years, if they do not step up their climate efforts.
So, potentially those holding government bonds would lose cash the moment that prices did move to reflect climate risks.
The two main problems
There are two main ways in how climate change is a problem from a financial point of view: Its physical effects, such as extreme weather events; and the impact of moving to a less carbon dependent economy.
"When a country is hit by a natural disaster — and these disasters are becoming more frequent and more severe — then property is affected, production capacity of agriculture, of industry is affected, even the very financial institutions may be affected," Kristalina Georgieva, the managing director of the International Monetary Fund, told CNBC earlier this month.
Back in 2014, the Urban Land Institute said that the total global damage caused by extreme weather on property and infrastructure was surging dramatically, exceeding $150 billion every year.
The more extreme and frequent weather events get, the higher the financial damage associated on property, but also on other parts of our economy.
In the case of a severe flood, for instance, a mortgage owner might lose the house and not be able to repay the full amount to the bank. When this happens to a wider group of people, then banks might struggle because their capital levels would become more limited.
As a result, lenders might decide to cut the number of loans they provide. As such, new people looking to get a mortgage might not be able to do so, and firms might also struggle to get loans to expand their operations.
Meanwhile, more and more countries are committing to becoming carbon neutral in the next few decades. Though necessary, this transition is also a risk.
"When that happens, when we move from high to low carbon intensity, industries that are in that area of high intensity become less valuable, asset valuation changes and this shift, if it is abrupt, can be quite difficult for financial institutions," Georgieva said.
Let's imagine that an oil-producing company has not changed its business model to focus more on renewable sources of energy. As societies use less gasoline, this firm may lose value. If many companies end up losing value because they aren't adjusting to a low-carbon society, then this could eventually spark some sort of market sell-off.
If the transition to a low carbon society "happens without too much preparation, this can cause a kind of a shock to financial markets," Dafermos said.
"Even if this doesn't affect an investor directly, there might be some indirect effect through the interconnection of the financial system, so it is very likely that many investors will see an impact from that. Even those who might already have decided to invest more in green financial products, if the financial system as a whole has a problem, they might also see some losses," he said.
Our economies rely to a large extent on financial markets. For instance, many companies use public markets to finance new projects. Pension funds invest people's savings in public markets too so they can retire one day.
If financial markets slide because the transition to a low-carbon economy happens abruptly, or because there's a liquidity problem in the financial sector, then savings could be lost and many companies could struggle to get funding.