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The Big Picture

The risks from physical climate change to financial stability deserve more attention

Mark Cornelius •  Head of Major Life Groups

Bank of England

Juan Duan •  Catastrophe Risk Specialist

Bank of England

We are at an inflection point in how we deal with climate change. We are past the debate about whether climate change is a real and present risk. It is now commonly understood that it is not only a risk that will affect us in the future. It is a risk that affects us now.

For most people, climate change poses a worrying physical threat to land, nature and communities. But physical impacts of climate change could be a risk to global financial stability as well.

It is our expectation that, in part as a result of the work of this conference, this risk starts to receive more attention.

Repairing the damage caused by physical climate-related events is expensive. Over the past few decades, inflation-adjusted insurance losses from these events have more than quintupled - from an annual average of around US$10 billion in the 1980s to around US$55 billion over the past decade.

These events are becoming much more common. The number of registered weather-related loss events has tripled since the 1980s.

Naturally, the driving factors behind insurance losses from these events are complex. But there are indications that climate change is having an impact. For example, Lloyd’s of London estimates that the 20cm of sea-level rise since the 1950s increased the 2012 Superstorm Sandy’s surge losses by 30% in New York alone.

However, understanding of these climate-related events is still insufficient.

There is a challenge in terms of disclosure. Without adequate disclosure, it is difficult to understand the impacts of climate change on corporate value chains, infrastructure and their transmission channels to financial markets.

There is also a challenge in terms of risk models. Currently, we lack the risk models to anticipate long-term climate change impacts. Over the past 20 years, the insurance industry has developed more sophisticated approaches to modelling risks from catastrophes and other weather-related events, although most models are aimed at providing estimates of near-term risk, rather than anticipating the impacts of longer-term climate trends.

And there is a challenge in terms of data. We lack adequate data to calibrate climate risks. We are entering an uncertain period. Basing our decisions on past weather patterns might not be appropriate to comprehend current weather risk, let alone predict future impacts.

That challenge is exacerbated by the possibility that climate events and their impacts could be non-linear. It is possible that passing certain thresholds might trigger catastrophes ranging from widespread drought to rapid sea level rise. By their very nature, we cannot be aware of these thresholds until we have passed them.

Some of these challenges are starting to be addressed.

At the Bank, assessing how well general insurers and reinsurers are identifying, measuring and mitigating weather-related risks has long been part of our work supervising insurers.

We published a review of insurers’ progress in adapting to climate change in late 2015, and are working to update and deepen our assessment this year. More recently, we have extended our focus to the financial risks faced by the UK banking system and will publish our review in the coming months.

The recommendations of the Taskforce on Climate-Related Financial Disclosures (TCFD) will help to make more data available to a wide range of stakeholders about how firms’ are positioning themselves with regard to risks and opportunities from climate change. In particular, climate scenario analysis can help market participants develop their strategy, inform investment decisions and communicate those choices to investors.

More information on the physical climate risks and opportunities that firms think they face would be very welcome.

It is our expectation that better disclosure of climate related risks and opportunities will provide a foundation to improve stakeholders ability to appropriately assess and price climate-related risk and opportunities in the future.

That mainstream financial institutions managing assets of $80trn have supported TCFD reflects their recognition that there is a relationship between a clear strategy for managing climate related risks and opportunities and long-term value creation.

They know that for markets to do what they do best – allocate capital efficiently and dynamically – they need the right information. When risks are unknown or ill-defined, the market cannot allocate resources in an efficient and profitable manner. For instance, appropriate disclosure of such risks could generate the opportunity for climate change-related risk transfer, creating a range of new financial products.

With better information and risk management as the foundations, a virtuous circle is being built with better understanding of tomorrow’s risks, better pricing for investors, better decisions by policymakers and a smoother transition to a low carbon economy.