From the FT:
In a sweeping assessment of the financial risks posed by global warming, Mark Carney acknowledged there was a danger the assets of fossil fuel companies could be left “stranded” by tougher rules to curb climate change.
The exposure of UK investors, including insurance companies, to these shifts is potentially huge,” he told a Lloyd’s of London dinner on Tuesday night, explaining 19 per cent of FTSE 100 companies were in the natural resources and extraction industries.
“The challenges currently posed by climate change pale in significance compared with what might come,” he said. “Once climate change becomes a defining issue for financial stability, it may already be too late.”
…Mr Carney said scientists had calculated the “carbon budget” the world could afford if it is to meet the 2°C target, and it amounted to between one-fifth and one-third of the world’s proven reserves of oil, gas and coal.
“If that estimate is even approximately correct it would render the vast majority of reserves ‘stranded’ — oil, gas and coal that will be literally unburnable without expensive carbon capture technology, which itself alters fossil fuel economics,” he said.
Fortunately for Australia, Kate Mackenzie, the former FTAlphaville doyen and now head of Manager of Investment and Governance at the Climate Institute, is pioneering similar thoughts Downunder. She recently released a report canvasing the risk of a carbon bubble bust to the Australian financial system:
As noted above, the FSB is examining how the financial system can address climate risk, and many countries are also considering this question. This is unlikely however to address Australia’s particular situation with regard to climate risk and financial stability. Although several submissions to the Financial System Inquiry in 2014 referred to climate risk, the inquiry’s final report made no mention of climate risk. The FSI concluded that Australian regulatory framework is broadly adequate regarding financial stability and systemic risk. This leaves the consideration of unique, unprecedented risks such as climate change at the discretion of regulators.
Here, we outline elements of Australia’s financial systems which are exposed to the effects of climate risk.
Banking
Australia’s biggest banks form an integral part of the country’s financial system. They are systemically important through their standard functions of credit intermediation and payment processing; along with their implicit and explicit government support, and their substantial representation in the stock market indexes.
Carbon risk: There is some evidence banks may be exposed to risk. MSCI estimates that as of 2014, around 10 per cent of the syndicated loan books of Australia’s big four banks were comprised of borrowers with stranded assets risks. However, a consistent methodology for identifying bank exposure is still being developed.
Physical climate risk: Australia’s banks are heavily concentrated in residential property,52 with mortgages making up about 66 per cent of their assets. The property market is also embedded in Australia’s financial system in even more direct ways. For example, a shortage of government bonds has led the RBA to develop a “Committed Liquidity Facility”, which allows banks, for a fee, to instead use their mortgage assets to meet liquidity ratios.
+ As a country with mostly coastal dwellings, these assets could collectively have a high exposure to the effects of climate damage. Increased precipitation could also lead to economically destructive events away from the coast, such as the Queensland floods of 2011.53
+ Many properties in Australia are believed to be under-insured and vulnerable properties are more likely to be underinsured.
+ Two recent Productivity Commission reports indicate that arrangements for provisions and funding of damage incurred from extreme weather events are inadequate.
+ Banks themselves may have limited visibility of their exposure to this risk, due to the lack of property insurance verification beyond the first year of the mortgage.
+ Infrastructure vulnerability and contingent liability provision are similarly problematic and potentially very costly.
+ This raises the prospect of the government as “insurer of last resort”, rescuing financial institutions, individuals, and/or other governments (e.g. federal government bailing out state and local).
Insurance
+ As disaster risk modelling is core to the general insurance business model, the insurance industry appears to be most active on climate risk – primarily on “physical” risk or “adaptation” risk, rather than through exposure via their portfolios. However the sector may be uneven in its handling of climate change, particularly for institutions that rely upon historical data without incorporating recent or likely future changing climate patterns.
+ Variance in utilisation of disaster data is evident among Australian insurers, raising the questions about risk pricing and capital adequacy.
+ Insurers do not spread risk across geographic areas, but calculate premiums based on the risk they calculate for a specific area, down to the address where possible.
+ Because of this, insurers will tend to respond quickly to changes in risks. Home insurance premiums in North Queensland rose rapidly since 2005-06, triggering an outcry among residents there. However the Australian Government Actuary identified higher cyclone payouts as a primary cause of the dramatic premium increases.64 Although this cyclone risk itself was not linked to climate change, it demonstrates that insurers will not redistribute higher risks from some households, but will instead leave some properties uninsurable.
+ Even when insurers and re-insurers do calculate climate-related risks in their own business, there are barriers to this information being transmitted to other segments of the economy or to policymakers. This is particularly clear in property insurance, which is generally only extended for 12-month periods, while the mortgager has exposure for the life of the mortgage.
Superannuation asset allocation and funds management
+ Australia has a relatively large (in relative and absolute terms) pool of commerciallymanaged pension assets. Domestic assets make up the vast majority of these investments, with a heavy weighting towards equities. The carbon intensive nature of Australia’s economy and stock market indicates our pensions are exposed to higher carbon risks than the international mean.
+ Some of these pension fund managers are beginning to consider and act upon climate risk that may affect the long-term interests of their members, as demonstrated by initiatives such as the Asset Owners’ Disclosure Project (AODP) and Investor Group on Climate Change (IGCC). This may have equity implications for members of funds that are not acting.
+ A significant number of Australians may be exposed to climate-related risk through their superannuation. While industry efforts to manage this risk remain voluntary and nonstandardised, individuals may have limited ability to make informed decisions.
Resources sector
Australia’s economy is highly exposed to demand for its main export commodities. These demand patterns have had significant implications for Australian monetary policy in the past decade. More recently, prices for some commodities have fallen sooner and more dramatically than anticipated. These falls have, in turn, put downward pressure on the Australian dollar, as the RBA has acknowledged.
There is evidence that Australia is already suffering from the imposition of rules relating to pollution as global seaborne coal prices have fallen. Wood Mackenzie, whose forecasts are widely used in the energy and mining industries, in January 2015 noted that tighter environmental regulations were already limiting industrial coal burn, and the development of such regulations would continue to “increase pressure on coal use”.
The Mercer report on climate investing identifies Australian, UK and Canadian equities as being “more sensitive” to climate risk, due to their higher exposure to carbon-intensive sectors. Australian equities are particularly singled out for additional sensitivity due to “the greater level of policy uncertainty in this market”.
Sovereign debt and capital markets
The fiscal policy implications of changes in commodity prices are relatively simple to project through impacts on tax receipts and capital inflows. The direct and indirect effects on financial systems, however, are less well understood.
On the macro economy, several recent reports estimate Australia’s carbon risk, including by the University of Oxford’s Smith School, Carbon Tracker Initiative and The Climate Institute,and Nature. These reports all indicate Australia has a relatively high exposure to this type of risk, compared to other developed markets.
These macro-economic risks might not, in themselves, pose a threat to financial stability. However, as Australia’s financial system is closely linked with foreign capital markets, a point underlined by the Financial System Inquiry, which states Australia’s “high interconnectivity domestically and with the rest of the world, and its dependence on importing capital” are characteristics which “give rise to particular risks”.
It’s conceivable that macro-economic shifts arising from climate change might have implications for Australian sovereign debt; something which has been noted by ratings agency Standard & Poor’s:
“Similar to the long-term challenges facing most other countries, Australia will need to adapt to the economic impacts of an ageing population and climate change… In our view, long term megatrends of aging populations and climate change will, over time, adversely impact government revenues, while the social needs, society’s expectations, and the costs of delivering social outcomes will all likely rise.“
Advisory firm Mercer also highlights Australian sovereign risk, in a June 2015 report on climate change and investment:
“We believe that the Australian economy is more susceptible to a policy shock than other developed markets given the uncertainty surrounding its national climate change policy, which currently lags other developed markets, combined with the level of dependency of the Australian economy on carbon-intensive sectors.”
Among developed market sovereign bonds, only Japan, New Zealand and Australia are singled out by Mercer in this way.
Infrastructure
Far-reaching changes to the energy system and related infrastructure such as transport are inevitable in the coming decades. Climate change will serve as a key driver for this change, which will likely be brought about through both policy and technology mechanisms. For example, the IEA states on current investment trends, by 2017, enough carbon-intensive infrastructure will already be in place to guarantee the 2°C limit. That would indicate two possibilities for infrastructure built after that date: either it must all be zero-emissions infrastructure; or it would need to be fully offset by carbon capture and storage, if the assets are to be fully utilised. A third option is that some of those assets become “stranded”.
“…attention needs be given to issues such as managing employment loss in the shift away from coal mining and handling high emissions assets which become “stranded” in the transition to a low-carbon economy.”
Full report.
