Making cents

In the wake of Hurricane Katrina, Louis Perroy argues that financial institutions are ignoring at their peril the risks posed by climate change

Financial institutions are increasingly paying attention to environmental matters and, more specifically, to climate change. However, the response needs to be more than just a PR exercise or CSR activity. Climate change is a reality and bottom lines are at risk. Climate change needs to be at the heart of financial institutions’ concerns. These institutions are vulnerable, as the timing of their liabilities lies in the future.

For example life insurance liabilities last around 30 years; general insurance long-tail claims are around 10 years; pensions cover individuals’ lives; and bank loans typically last around 20 years. As a result, according to the experts, the timing of climate change’s catastrophic consequences may well coincide with liabilities of financial institutions and significantly increase these insurance claims.

It is troubling, therefore, that climate change is not factored into projections of future liabilities or assets within these institutions. This is especially the case when conducting Asset and Liability Management (ALM) work, a necessity for the management of financial institutions which is usually conducted by actuaries. Institutional investors typically have medium- to long-term liabilities, and the duration and return of assets held will have to match these assets.

Additionally, and more worryingly, today the only financial institutions talking about climate change as impacting their claims experience are reinsurance companies. The role of reinsurance companies is to help insurance companies in their claims exposure by insuring ‘abnormally’ important claims or aggregations of claims. The largest worldwide reinsurance companies are already witnessing an increase in size and frequency of catastrophic claims, deriving from heatwaves, droughts, bush fires, tropical and extra-tropical cyclones, tornadoes, hailstorms, floods and storm surges in many parts of the world. However, climate change will have many other direct impacts on insurance claims.

For example, property is vulnerable to significant climate change events such as floods, windstorms, subsidence and coastal squeezes. Agricultural insurance will also be affected. Forestry insurance has already witnessed higher rates in certain areas due to storm increases. In the case of health insurance, the high level of CO2, coupled with high temperatures, enhances the potential for pollen production and therefore an increase in respiratory problems. New mosquito-related diseases may also appear and the adjustment cost to new diseases will also be partially borne by the insurance sector.

Advance on all fronts

In parallel to liabilities, financial institutions should consider medium- to long-term impacts of climate change on assets. This especially makes sense if assets are found not to be a safe long-term investment, and to have higher volatility due to serious adjustments ahead.

The main sectors which may directly suffer from impacts of climate change include not only property but also agriculture, forestry, fishery, food and beverage distribution, infrastructure and utilities, transportation (water, trains, highways), health, and the insurance/reinsurance sectors.

For instance, property investment, which traditionally represents between 10 and 25% of financial institutions’ assets, will be vulnerable from an increase in the number of climate change-related events.

Not only are assets affected by the physical impact of climate change, but they are also at risk from climate change mitigation regulations, such as EU directives, the Kyoto Protocol and emissions trading schemes. It should be noted that these regulations affect various greenhouse gas-emitting sectors in which financial institutions are large investors.

These risks cover such a wide variety of sectors across the economy, it prompts one to ask what the overall consequence of such disruption could be at a world macro-economic level. Other concurring factors may also contribute to an overall economic instability, for example an energy supply crisis with gas and oil reserves peaking in 15 to 20 years, a situation which could be exacerbated by political crises in the Middle East.

Global warming, global conflict

Global environmental issues, such as loss of biodiversity, should also be taken into account. Human population increases, especially in tropical countries, coupled with modernisation of developing countries, and the impact of climate change, will all conspire to affect the world’s natural biodiversity. This may seriously hinder the potential for adaptation to new situations linked to medical or food issues. Also, experts speculate that the problem of water shortage may become so extreme in some areas of the world that it could lead to human mass migration and be a potential cause of international conflicts.

Given all the aforementioned climate change-related issues, it would not be unrealistic to assume that the developed world will experience, before 2050, a crisis of confidence in world economies, leading to a long and deep recessionary period.

Although on the liability side of insurance companies, insurability selection and premium increases can be made, there is less leverage on assets. Therefore impacts on assets deserve even more attention when conducting ALM work and other projections.

So, faced with these issues, what can financial institutions do? It has been encouraging to see the creation of organisations that are engaging financial institutions in the climate change debate: these organisations include the Carbon Disclosure Project (CDP), the UK Institution Investors Group on Climate Change, and the Investor Network on Climate Risk (INCR).

If it is known that climate change will have a significant impact on the profitability of a financial institution in future years, measures of adaptation (adapting the insured element to the likely impact of climate change so that it endures less damages and incurs less loss) will be strongly encouraged by the company and may become a condition of insurability.

Mitigation options which consist in modifying the source of climate change, may appear not to make financial sense now, as mitigation is costly, very uncertain, and extremely complicated to put in place. However, adaptation, currently the obvious option, can only be a temporary measure, as it does not address the source of the issue.

However, mitigation actions can be strengthened through a coordinated approach by institutional investors. These investors could, by working together, opt for mitigation measures which would have long-term financial benefits. These measures could include:

  • Putting pressure on large-emitting multinationals to address climate change and develop a clear agenda on progressively reducing their greenhouse gas emissions;
  • Progressively developing investment vehicles specialised in

    direct investments in mitigation concerns such as renewable energy companies and low carbon emission companies. These may become very profitable investments in future years when traditional energy sources start to become scarce;
  • Developing funds specialising in investments that generate carbon credits. These could be managed as a long-term commodity, likely to appreciate in value (considering the underlying climate change issues at stake).
  • Practical recommendations

    This need not be blue sky thinking; pension funds, insurance companies and other financial institutions have a very significant leverage over financial markets.

    A series of more practical recommendations should also be made to actuaries, and other experts of financial institutions. These should include the need:

  • To understand better the occurrence of natural catastrophes as a result of climate change;
  • To understand better

    the impact of climate change on health and mortality of individuals; and,
  • To conduct better analyses of asset investments from a climate change perspective.

  • Financial institutions should use their large investment base and their insurance coverage to put pressure on large emitting sectors or industrial companies to reduce their greenhouse gas emissions.

    It’s time for financial institutions to recognise the risks of climate change, not only in relation to their own assets and liability but also the role they can play in helping to tackle climate change and its effects.

    Louis Perroy is from specialist merchant bank, Climate Change Capital.

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