The Role of Financial Services in Combating the Climate Crisis

Introduction

The impact of climate change is already being felt. Between 2000 and 2019, there were more than 7,300 natural disasters globally, twice as many as between 1980 and 1999 [1]. These natural disasters cause loss of life, destruction of homes and displacement of peoples. In combating the problem, governments are generally strong in words but weak in action.

Data published in 2022 by Climate Action Tracker, an independent research group, revealed that none of the world’s biggest emitters – China, the United States, the European Union and India – have reduced their emissions enough to meet the goals set in the landmark Paris Agreement of 2015 [2].

If the agreed upon targets are to be met, change is needed, and fast.

And while it is the role of governments to set policy, other sectors are vital in enabling change, the financial sector chief amongst them.

Speaking in 2020, Vasileios Madouros, then Director of Financial Stability (now Deputy Governor) at the Central Bank of Ireland, stated that, “A climate-resilient financial system is a necessary condition to enable the transition to a low-carbon economy…we cannot have a situation where concerns around the resilience of the financial system act as an obstacle to that transition” [3].

The financial threat

In a joint report by Mazars and the Official Monetary and Financial Institutions Forum (OMFIF), based on research and surveys with 33 central banks and regulatory authorities, 70% of survey respondents considered climate change a major threat to financial stability [4]. Just over half of central banks (55%) said they were monitoring climate risks, with 27% saying they were actively responding to them [5].

Meanwhile, a London School of Economics study posits that climate change could cut the value of the world’s financial assets by US$2.5 trillion [6].

Financial exposure to catastrophic climate events, potential overvaluation of companies in fossil fuel and resource-scarce industries, increased regulation to enforce Sustainable Development Goals, rising shareholder activism, and the rapid increase in consumer scrutiny on corporate behaviour are just some of the issues around which financial institutions need to be wary [7].

Sustainable finance in Ireland

As host to a large, internationally-focused financial sector, Ireland will be impactful inand impacted by any changes moving forwards. The value of Ireland’s financial system’s total assets comes to more than €5tn, while it also boasts the second largest investment fund sector in the euro area [8].

Definitions and disclosure

For the financial system to be effective in ushering in a greener tomorrow, it’s necessary to introduce an element of standardisation around definitions – what do we mean when we say “green”, “sustainable” etc? A consistent framework is required, otherwise institutions are liable to set their own definitions, potentially ones that serve their own interests. Inconsistent definitions may even lead to “green washing”, with companies misinforming investors as to the sustainable credentials of their investments.

Equally vital is disclosure. Investors need to be able to assess any climate-related aspects of their investments. In his 2020 speech, Madouros pointed out that in instances in which a “financial product is sold as promoting environmental characteristics, the financial provider will be required to disclose information on the degree of compliance with the taxonomy” [9].

Risk

Those taking part in the aforementioned OMFIF report considered climate change a threat to financial stability because it is. It is an unprecedented and unpredictable source of risk, with physical risks and transition risks widely regarded as the key areas in need of focus.

Physical risks refer to the financial impact of floods, droughts, wildfires, earthquakes, rising temperatures – any problem, essentially, that is climate-induced. Such events impact various financial sectors but most especially insurance.

Weather-related insured losses – adjusted for inflation – have increased by several multiples since the 1980s [10]. As these events become more commonplace, insurance premiums shift. Some such events may become so commonplace that insurers grow reluctant to insure them at all, with obvious implications for those who would be cut adrift by such a move.

According to AON’s 2020 Weather, Climate & Catastrophe Insight report, the last decade was the costliest in terms of natural disasters, with the total economic damage and losses amounting to 2.98 trillion US dollars. Insurance pay-outs peaked, as 845 billion US dollars were paid out by private and public insurers [11].

We are not talking about chump change. And Ireland is not immune from the fallout.

“The Irish financial system is exposed to these physical risks,” said Madouros. “Our insurance sector is very international, with exposure to catastrophic weather events across the globe, from South East Asia to the South East of the United States. Irish banks are heavily exposed to property, with around two thirds of their loan exposures secured on property. So it is important that these risks are assessed, managed and priced appropriately, in a forward-looking way and taking into account the latest insights from climate science” [12].

Transition risks refer to any economic fallout brought about by the process of shifting to a low-carbon economy. For example, the asset price of energy firms with investments in oil and gas fields, who are at the mercy of any government-mandated acceleration or deceleration of sustainable initiatives. Outside the energy sector, the transition from petrol and diesel cars to electric will continue to have a notable effect. Look no further than Germany’s current economic predicament to understand the perils of being caught flat-footed when it comes to acting on sustainable trends in the automotive sector [13].

A further risk is that the rate and scale of any green transitions are at the mercy of geopolitical shifts that cannot be controlled and are likely to lack consistency. It’s possible that as the economic realities of transforming the global economy take hold, inequality will rise. This could see populist movements take power on the back of an anti-green ticket. The implications of this could be seismic, especially if it were to take place in a nation that holds sway over the global economy.

Climate litigation

In his keynote speech at the ECB Legal Conference of 2023, Member of the Executive Board of the ECB Frank Elderson warned banks that they needed to prepare themselves to face climate and environment-related litigation. To mitigate this risk, he suggested they put in place “realistic, transparent and credible transition plans that banks can and actually do implement in a timely manner.” Should they fail too, he said, they could find themselves the target of unwanted litigation [14].

While such litigation has generally so far only been targeted at States and corporations within the energy field, Elderson proffered that financial companies are next. He suggests that the litigants hope that by targeting banks and other financial companies, they can “turn off the taps” of funding to high emitters. Globally, some 560 cases of this type have been filed since 2021, often brought or supported by NGOs who possess resources and clout, and cannot be dismissed as armchair activists or trivial ideologues.

Economic benefits

That said, the motivation to embrace sustainable initiatives shouldn’t simply be to avoid getting in trouble. Outside of the obvious ecological benefits, embracing green initiatives offers opportunities for long-term value creation.

“The move towards more sustainable business models translates to concrete opportunities for companies to become more innovative and reduce the now high costs of production and waste management,” writes Joukje Janssen of PwC, citing the the money companies have saved by shifting from linear to circular models in plastic use as proof that green initiatives offer credible fiscal rewards, as well as ecological ones [15].

The role of financial services in combating the climate crisis

While it is down to governments to put in place any green policy shifts, the financial sector is pivotal in making any transition possible. The financial implications of climate change are enormous; to avoid disaster, clear definitions and disclosures as to sustainable compliance are required to ensure all parties are singing from the same hymn sheet.

Physical and transition risks pose a number of threats to the financial sector and the global economy more broadly, as does the social upheaval that could follow a potential rise in inequality brought about by such a seismic economic pivot. Banks should ensure their houses are in order so as to be prepared for any incoming climate litigation, though should ideally be motivated more by the prospect of a greener tomorrow than by covering their own backs.

To truly address the climate crisis and fulfil the pledges of Paris, action is needed quickly. Financial services cannot dictate the direction of travel themselves, but they can provide the clearest path.

The Role of Financial Services in Combating the Climate Crisis

Introduction

The financial threat

Sustainable finance in Ireland

Definitions and disclosure

Risk

Climate litigation

Economic benefits

The role of financial services in combating the climate crisis

More on Climate Change

About the author

Shay Dalton