A team of economists recently analysis 20 years of peer-reviewed research on the social cost of carbon, an estimate of the damages of climate change. They concluded that the average cost, adjusted for improved methods, is significantly higher than the most recent figure from the U.S. government.
This means that greenhouse gas emissions, over time, will have a greater impact than regulators anticipate. As tools for measuring the links between weather and economic output evolve – and as interactions between weather and the economy amplify costs in unpredictable ways – damage estimates have only grown. increase.
It’s the kind of data that one might expect to set off alarms across the financial industry, which closely monitors economic developments that could affect stock and loan portfolios. But it was difficult to detect even a ripple.
In fact, Wall Street news lately has mostly been about a retreat from climate goals rather than a recommitment. Banks and asset managers are withdraw international alliances on climate and friction to their rules. Regional banks are intensify lending to fossil fuel producers. Sustainable investment funds supported paralyzing exitsand many have collapsed.
So what explains this apparent disconnect? In some cases, it’s a classic Prisoner’s Dilemma: If companies collectively shift to cleaner energy, a cooler climate will benefit everyone more in the future. But in the short term, each company has an individual incentive to profit from fossil fuels, making the transition much more difficult to achieve.
And when it comes to avoiding climate damage to their own operations, the financial sector is genuinely struggling to understand what a warming future will mean.
To understand what’s happening, put yourself in the shoes of a banker or asset manager.
In 2021, President Biden reentered the United States into the Paris Agreement and its financial regulators began issuing reports on the risk that climate change poses to the financial system. A global pact of financial institutions has made commitments worth $130 trillion to try to reduce emissions, confident that governments would create a regulatory and financial infrastructure to make these investments profitable. And in 2022, the Inflation Reduction Law was adopted.
Since then, hundreds of billions of dollars have been invested in renewable energy projects in the United States. But that doesn’t mean they’re a safe bet for people paid to develop investment strategies. Clean energy stocks have been hit by high interest rates and supply chain problems, leading to the cancellation of offshore wind projects. If you had bought some of the largest solar energy exchange-traded funds in early 2023, you would have lost about 20% of your money, while the rest of the stock market soared.
“If we think about how best to move your portfolios in the direction that will benefit them, it’s really hard to do,” said Derek Schug, head of portfolio management at Kestra Investment Management. “They’ll probably be great investments over 20 years, but when we’re judged over one to three years, it’s a little more difficult for us.”
Some companies are targeting institutional clients, such as civil servants’ pension funds, who want the fight against climate change to be part of their investment strategy and are prepared to take a short-term hit. But they do not constitute the majority. And over the past two years, many banks and asset managers have backed away from any climate labeling, for fear of losing business to states that frown on such concerns.
In addition, the war in Ukraine has weakened the financial arguments in favor of a rapid energy transition. Artificial intelligence and the movement toward greater electrification are increasing demand for electricity, and renewable energy has not kept pace. So the banks continued to lend to oil and gas producers, which generated record profits. Jamie Dimon, the chief executive of JPMorgan Chase, said in his annual letter to shareholders that simply stopping oil and gas projects would be “naive.”
This all depends on the relative attractiveness of investments that would slow climate change. What about the risk that climate change poses to financial sector investments, through more powerful hurricanes, heat waves that destroy power grids, wildfires that destroy cities?
There is evidence that banks and investors incorporate some physical risks, but much of this remains hidden, unnoticed.
Over the past year, the Federal Reserve has asked the nation’s six largest banks to examine what would happen to their balance sheets if a severe hurricane hit the Northeast. A summary Last month it was reported that institutions were struggling to assess the impact on loan default rates due to a lack of information on the characteristics of real estate, their counterparties and especially their coverage insurance.
Parinitha Sastry, assistant professor of finance at Columbia Business School, studied shaky insurers in states like Florida and found that coverage was often much weaker than it appeared, making mortgage defaults more likely after hurricanes.
“I’m very, very concerned about this because the insurance markets are this weak and opaque link,” Dr. Sastry said. “There are parallels with some of the complex links that occurred in 2008, where there is a weak and unregulated market that extends into the banking system.”
Regulators fear that failing to understand these ripple effects could not only put a single bank in trouble, but even become a contagion that undermines the financial system. They have set up systems to monitor potential problems, which some financial reformers have critical as inadequate.
But even if the European Central Bank has poses a climate risk factored into its policy and oversight, the Federal Reserve has resisted taking a more active role, despite indications that extreme weather is fueling inflation and high interest rates are slowing the transition to clean energy .
“The argument has been: ‘Unless we can convincingly demonstrate that this is part of our mandate, Congress should take care of it, it’s none of our business,'” said Johannes Stroebel, professor of finance at New York University’s Stern School of Business.
Ultimately, this view may prove to be correct. Banks are in the business of managing risk, and as climate forecasting and modeling tools improve, they can stop lending to obviously risky businesses and locations. But that only creates more problems for people in these areas when credit and business investment dry up.
“You can conclude that this does not pose a threat to financial stability and that significant economic losses can still occur,” Dr. Stroebel noted.
While it remains difficult to assess where the risks lie in one’s portfolio, a shorter-term uncertainty looms: the outcome of the US elections, which could determine whether additional measures will be taken to address climate concerns or whether efforts existing ones will be canceled. An aggressive climate strategy might not perform as well under a second Trump administration, so it may seem wise to wait and see how it plays out.
“Given how our system has evolved so far, it is evolving so slowly that there is still time to move to the other side of the proverbial fence,” said Nicholas Codola, senior portfolio manager at Brinker Capital Investments.
John Morton served as climate advisor to Treasury Secretary Janet L. Yellen before joining the Pollination Group, a climate-focused investment management and advisory firm. He observed that large companies are hesitant to invest in climate-sensitive investments as November approaches, but believes “two things are wrong and quite dangerous about this assumption”.
First: States like California establish stricter rules for carbon-related financial disclosures and could step it up further if Republicans win. And second: Europe is gradually implementing a “carbon border adjustment mechanism”, which will punish polluting companies who wish to do business there.
“Our view is: be careful,” Mr Morton said. “You will be at a disadvantage in the market if you end up with a big bag of carbon in 10 years. »
But at present, even European financial institutions are under pressure from the United States, which – despite providing some of the most generous subsidies for renewable energy investments so far – has not imposed any price on carbon.
Global insurance company Allianz has developed a plan to align your investments in a way that would avoid warming above 1.5 degrees Celsius by the end of the century, if everyone did the same. But it’s difficult to tilt a portfolio toward climate-friendly assets while other funds are taking on polluting companies and reaping short-term profits for impatient clients.
“That’s the main challenge for an asset manager: to really engage the client,” said Markus Zimmer, an economist at Allianz. Asset managers do not have sufficient tools to divert money from polluting investments to clean investments if they want to stay in business, he said.
“Of course it helps if the financial sector is ambitious, but you can’t really replace the lack of action by policymakers,” added Dr. Zimmer. “In the end, it’s very difficult to get around there.”
According to new search, the benefit is greater the faster decarbonization occurs, because the risks of extreme damage increase over time. But without a uniform set of rules, someone is bound to reap the immediate benefits, at the expense of those who don’t – and the long-term outcome is unfavorable for all.
“The worst thing is if you commit your business model to 1.5 degrees of compliance and three degrees are achieved,” Dr. Zimmer said.
