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Climate change is already impacting global ecosystems, livelihoods and communities. One of the most significant and underrated impacts on climate change is its influence on global financial systems. From physical risks and damage to transitional and regulatory factors, the financial sector is navigating how to mitigate the impacts of climate change, adapt to new realities and support preventative measures and policies.
Physical Risks: A Tangible Threat
Physical risks arising from climate change can have a devastating impact on financial assets. Natural disasters such as hurricanes, floods, and wildfires are becoming more frequent and intense, resulting in significant property and infrastructure damage and disruption to economic activity. For instance, the 2021 floods in Western Germany caused widespread damage to infrastructure, businesses, and homes. The floods caused an estimated €33 billion in direct damage in Germany alone, making it one of the costliest natural disasters in the country's history. The financial impact of the floods was significant, with insurers facing large claims and businesses experiencing disruptions to their operations. Additionally, extreme heatwaves have become more frequent in Southern Europe, leading to agricultural losses, wildfires, damage to infrastructure and increased energy demand. Heatwaves reduce productivity and performance of businesses and industries, with a link between heatwaves and impact on national GDP.
Regulatory Risks: A Changing Landscape
Climate change is also influencing regulatory changes that can have significant financial implications. Governments worldwide are implementing policies and regulations to mitigate climate-related risks and promote sustainable economic growth. These regulatory changes include carbon pricing mechanisms, renewable energy mandates and disclosure requirements for climate-related risks. The European Union has introduced the European Union Emissions Trading System (EU ETS), which places a cap on greenhouse gas emissions and requires companies to purchase permits to emit. This system can increase costs for businesses, particularly those in energy-intensive industries. Additionally, many financial regulators are now mandating climate-related risk disclosures, requiring financial institutions to assess and report on their exposure to climate-related risks.
Transition Risks
Transition risks are the potential economic and social costs associated with shifting towards a low-carbon economy. They arise from the necessary changes in policies, technologies, and market structures. The transition to a low-carbon economy may require significant investments in new technologies and infrastructure. This can create opportunities for some sectors but also pose risks to others, as traditional industries may face obsolescence. Financial institutions need to assess the potential impact of these disruptions on their portfolios.
In Europe, the European Union is implementing climate policies such as the European Green Deal to reduce greenhouse gas emissions and make Europe climate neutral by 2050. These policies may lead to increased costs for businesses, particularly those in carbon-intensive sectors. This can affect the profitability and credit ratings of these businesses and increase the risk of defaults for financial institutions.
Responses to Climate Risks
Recognising the growing importance of climate change, the finance sector is taking steps to manage and mitigate climate-related risks. Financial institutions are conducting assessments to identify and quantify their exposure to climate-related risks, such as physical damage and regulatory changes. By analysing various climate scenarios, financial institutions can assess the potential financial impacts of different climate-related events and develop strategies to manage those risks. The European Central Bank has been a key driver of climate risk management in the European financial system, conducting stress tests and encouraging banks to integrate climate considerations into their risk management frameworks.
Many financial institutions are incorporating climate-related factors into their investment decisions, seeking to invest in companies and projects that are resilient to climate change and contribute to a low-carbon economy. Banks in the Nordic region have been pioneers in climate-related financial services, offering a wide range of green products and services. Banks such as HSBC have made commitments to reduce their carbon footprint and support the transition to a low-carbon economy.
As climate related risks continue to evolve, it is up to financial institutions to create and adapt strategies to manage and mitigate the impacts. By taking proactive steps and adopting sustainable practices and policies, financial institutions can contribute to a more sustainable and resilient future.
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