Climate change is expected to have a dramatic impact on our environment over the next few decades – and quite possibly beyond. Since the 1980s, each decade has been warmer than the previous one and this trend is expected to continue. Climate change is no longer being considered primarily an environmental issue, but a multi-faceted source of economic and financial risks that could threaten the stability of the financial ecosystem.
Our new white paper, Climate-Related Financial Risk: A Financial Market Infrastructure’s Perspective, presents our thoughts on how climate-related financial risk applies to DTCC and, by extension, other Financial Market Infrastructures (FMIs) – and how the industry currently has the necessary resources to address these risks in a proactive manner.
Climate Change: At a Glance
Natural phenomena have an impact on the Earth’s climate; however, human activities have been the main driver of a global rise in average temperatures since the 1800s.
Fossil Fuels Fact: Greenhouse gas emissions from human activities are the most significant driver of observed climate change since the mid-20th century. Fossil fuels – coal, oil and gas – are by far the largest contributor to global climate change, accounting for more than 75% of GHG emissions and nearly 90% of all carbon dioxide (CO2) emissions.
Climate Concerns: With increases in global average temperatures, climate models indicate a rise in climate hazards including more severe storms, increased drought, rising sea levels and declining biodiversity, among others.
Climate-Related Physical Risks
Damages caused by climate-related events have grown to about $133 billion per year in the U.S. alone. Not taking any action to reduce the effects of climate change will likely lead to increased acute and chronic physical risks to the global economy.
Acute physical risks: The risks from economic costs or financial losses caused by the increasing severity and frequency of extreme weather events such as floods, tropical cyclones, heatwaves, landslides, hailstorms and wildfires.
Chronic physical risks: The risks from economic costs or financial losses caused by longer-term gradual climate shifts including rising sea levels, soil degradation, desertification, deforestation and other environmental changes to the ecosystem.
Climate-Related Transition Risks
There is already evidence that the market values of firms in some heavily polluting industries are being impacted by policy measures and market trends related to a transition to a low-carbon economy.
Transition risks: The risks from economic costs or financial losses caused by the process of adjusting towards a low-carbon economy may be unpredictable, disorderly, or otherwise disruptive.
Key Drivers: Transition risk is driven by several developments which have the potential to accelerate, slow or disrupt the transition path towards an economy that reduces the global greenhouse effect including changes in public sector policies and regulation, technology and market preference.
Indirect Impact for FMIs
While financial institutions and non-financial firms are directly exposed to climate-related financial risk, FMIs are only exposed indirectly. This indirect exposure of FMIs to climate-related financial risk is well within the current boundaries of existing FMI risk management models because of two key reasons:
Business Continuity Programs: While extreme weather events may trigger sudden shocks, FMIs have established robust business continuity programs that have proven that they can effectively mitigate this type of risk (i.e., acute physical risk).
Long-Term Materialization: Even in worst-case projections, other types of risk (i.e., chronic physical risk and transition risk) are expected to materialize over a multi-year or multi-decade time horizon, which is significantly longer than the risk horizon that is utilized by FMIs.
The Name’s Bond, Green Bond
The market for green bonds, which are fixed-income securities that raise capital to fund specific climate-related projects or other activities that promote environmental sustainability, have grown over the past several years.
Safeguarding Stability: Green bonds can play a significant role in contributing to the funding required to address the global challenges of climate change. However, for FMIs to continue safeguarding financial stability, it’s vital that they not be given preferential treatment if used for collateral purposes or in terms of how they are otherwise risk managed.
Bubbling Over: The creation of a potential “green bubble” is a potential unintended consequence of the success of green bonds that should be monitored as it might pose certain risks. The lack of standards around green bonds may be another problematic area.
The climatic changes we have witnessed so far will likely be eclipsed by far more dramatic environmental shifts in the years and decades to come. As such, it is encouraging to see growing levels of public awareness and debate around climate-related issues. As much as our systemic risk white papers serve to articulate our views on important topics, their primary goal is to promote dialogue. As such, we encourage you to share your comments and feedback with us.