Financial time bomb: The risks of climate inaction to the global economy

Physical consequences, such as severe weather conditions and the carbon transition resulting from shifting to a less carbon-dependent economy, are the two primary causes. Physical vulnerabilities are increasing in frequency and severity. These threats impacted the economy's financial stability as they directly affected property, industry and agriculture. In 2019, climate catastrophes cost the world's economy $146 billion. Insurers covered a total of $60 billion of it. According to Swiss Re, one of the biggest insurance firms, extreme weather occurrences are becoming more frequent and severe. This indicates that many sectors are preparing for future losses that will be considerably more serious. Moreover, these losses are not merely data or news headlines but have bearing on tens of millions of people.

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Is climate change triggering the financial time bomb?

So, how might climate change lead to a financial disaster? Let's take the potential consequences of catastrophic incidents like the sinking of Joshimath, Uttrakhand, as an example. In the event of such an incident in a populous location, not only would the property be destroyed, but there will be loss of human lives, nature, and livestock. According to reports, in 2021, natural disasters caused a loss of $ 280 billion, and approximately 60 percent of this total was uninsured. This implies that mortgage and commercial lenders like banks will never get repaid by uninsured homeowners or businesses. An increase in such incidents will result in bad loans, which may push banks to go for higher interest rates or extend fewer loans. Potential homebuyers and companies will find it difficult to obtain financing, and it won’t be long until the economy grids. The Global Financial Crisis (2007-2008) was brought on by banks realising that assets backed by real estate had almost lost all their value. Hence, the global economy shrank due to the subsequent credit crunch.

Transition to a low-carbon economy

To safeguard ourselves against increasing natural calamities, we must transition from a high to a low-carbon economy. During fluctuating financial markets, businesses with a high carbon intensity lose value. This transition may be challenging for financial institutions if it is sudden. To achieve carbon neutrality, more nations are pledging to cut their CO2 emissions and use carbon-capturing technologies to bring in the necessary checks. However, many firms will need to alter their processes and operations to move towards carbon neutrality. For instance, most oil companies have yet to change strategies to incorporate more renewable energy sources in their operations. More renewables in the energy system will entail less consumption of oil and hence a decline in the company's worth and, finally, less appeal to investors. This may lead to a market sell-off if businesses in an industry stay the same for a low-carbon future.

Financial markets may experience a shock if this occurs with more planning. There could have a ripple effect due to the interconnection of the global financial system, and industries that have already invested in green finance, like sovereign green bonds and so on, will also lose. The financial markets worldwide are so intertwined that; a tsunami in Japan or wildfires in California might affect your stock investments or a worker's retirement plans somewhere in Europe. A carbon tax is one factor that may influence investors' positions in the market. These taxes, which would charge businesses based on their emissions, are now being debated in numerous nations. Governments expect that having these businesses pay more would encourage them to reduce their pollution to firms whose output is overly dependent on coal, gas, and oil. The banks that have lent money to these businesses may need stability.

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How to reduce the risks posed by climate change?

The most fundamental step is to design, develop and implement the policies and investments to facilitate the transition to a new climate economy which is low carbon and climate resilient. Additionally, we need a focused approach to our financial systems because they are crucial for the operation of our economies. For instance, the European Union is putting the European Green Deal into practice by working on several initiatives. To revitalise the Indian economy and generate employment, the government of India recently unveiled sovereign green bonds and a significant $4.3 billion investment in green technologies. These policies can help to revitalise economic growth while carving the path towards net zero.  

Investing in a low-carbon society may also have broader economic advantages. According to IMF, the world economy may profit from a five percent of GDP green investment, together with progressively rising carbon taxes and attention to those impacted by the transition; this can boost growth by 0.7 percent annually over the next 15 years.

Climate change is the biggest issue for society, and we may be the last generation who have the opportunity to overcome this challenge. This brings the greatest opportunities of our lifetimes too. We can generate avenues of growth and employment by investing in climate resilience and innovative technologies. Climate change has both a human and environmental toll and a substantial financial cost and could lead to the world’s next big financial crisis. It’s a financial timebomb in the making if not curbed on time.

Anil Mehta works as Principal – Yield and Service Delivery with Secure Meters Limited. He is a student of the Advanced Management Programme in Public Policy at the Indian School of Business.

Anjal Prakash is the Research Director of the Bharti Institute of Public Policy at the Indian School of Business. He contributes to IPCC reports.