Climate change is increasingly understood as one of the defining economic challenges facing the world in the 21st century. While the direct impacts of the climate crisis on economic activity are fairly clear, this paper explores a deeper, more indirect impact: the potential for climate change to trigger a financial crisis.
Scientists and economists already agree that global warming is and will be economically disastrous. The cumulative, manifold damage that climate change will bring--decreased labor productivity and the spread of communicable diseases from higher temperatures, diminishing agricultural yields amid drought and desertification, and physical losses from extreme weather events--will cost trillions. (1) Experts estimate that, without significant emissions mitigation, the damage will shave more than seven percent from global Gross Domestic Product (GDP) by the end of the century. (2)
Developing countries will inevitably bear the brunt of this damage, as they have little in place to shield them from what warming will bring. Low-lying atolls like the Marshall Islands and Kiribati will be underwater by the end of the century or sooner on current emissions trajectories. (3) In Bangladesh, rising sea levels are expected to submerge nearly 20 percent of the country while stronger, more frequent cyclones will permanently ruin arable lands farther inland. (4)
The United States will also face major costs with a loss of more than ten percent of its GDP under a business-as-usual scenario. (5) The Congressional Budget Office (CBO) estimates that economic losses from hurricanes and storm-related flooding alone will cost $54 billion annually under current climate and weather conditions --a figure that would only increase with more frequent and extreme events. (6) A New York Federal Reserve regulator put the direct damages from climate change at more than $500 billion over the last five years. (7)
However, the United States has a key advantage: deep financial markets that can provide insurance against economic losses. When a flood or wildfire hits a home or business, insurance kicks in. Insurers help economies absorb shock: They profit when skies are calm and make payouts when disaster strikes. The system functions as long as insurers can reasonably determine how likely and costly certain risks are.
Yet climate change stands to ruin the arithmetic that insurers and financial markets use to assess these risks. Simply put, warming will make rare events today far more common in the future. As Mark Carney, the governor of the Bank of England, warned in 2015, "[t]he catastrophic norms of the future are in the tail risks of today." (8)
As this paper describes, the unprecedented scale of these risks has the potential to spark a major financial crisis. If climate-related catastrophes trigger the insolvency of a major insurer, contagion through mortgage and other financial markets could be rapid, deepening the economic costs and slowing recovery. In short, climate change could strike twice, first through its direct impacts on the economy, and second through a major financial meltdown.
The global economy's future could hinge on the United State's ability to measure and mitigate this risk and the ensuing impact. The last global financial crisis proved that the United States is so central to the global financial system that its problems can bring down markets around the world. Further, all developed countries are facing the same task of mitigating the exposures of their financial markets to climate change.
Lawmakers would do well to heed this warning by investing in reducing emissions, boosting the resilience of physical infrastructure to climate change, and requiring the disclosure of climate-induced risk throughout the financial system. Failure to act would risk turning the global financial system from an asset to a liability, as the physical damage to local communities spreads throughout the economy, killing investments and business confidence; erasing stocks and pension value; and fueling a major economic downturn.
THE FINANCIAL BOILING POINT
To understand the damage that climate change could unleash on the global financial system, look no further than the 2008 global financial crisis that commenced when the U.S. housing market bubble burst. While a housing bubble differs greatly from a hurricane, their impacts on the financial system could be uncannily alike.
A financial crisis can take many forms, but generally involves a major failure in the system of financial intermediation, the web of transactions that matches depositors and investors with investment opportunities, and borrowers with sources of funding. (9) Often, this failure reflects concerns about the solvency or liquidity of the financial institutions such as banks that perform these matching functions, driven by unexpected falls in the value of the assets these institutions hold.
Leading up to 2007, U.S. banks and their subsidiaries sliced and diced subprime mortgage loans into securities that promised attractive rates of return but hid the risk of default inherent to homeowners with poor credit history. In theory the risk was small as long as the housing market continued to appreciate, as the borrower could always refinance or sell the house for a higher price in the face of pending default.
When the U.S. housing bubble inevitably burst, the nation's largest financial institutions were left standing with worthless mortgage-backed securities. As economist Alan Blinder describes, this "high stakes game of musical chairs turned out to be remarkably short on seats, and large swathes of the financial industry fell rudely to the floor." (10) Everyone knew that prices could fall at some point, but nobody expected the fall to be so great, or so widespread. Risk models built on historical data turned out to be woefully wrong, and losses piled up well beyond what anyone had thought possible. (11)
Importantly, the interconnected nature of global financial markets--and the crucial role of U.S. institutions at the center of this web--meant that the crisis spread rapidly beyond U.S. borders, triggering financial market failures around the world. (12) These spillovers triggered a recession in global GDP, and more than a decade on, the effects continue to reverberate through the economies of many countries. (13)
Climate change has the potential to trigger a similarly large and unexpected collapse in asset values. The latest report from the United Nations' Intergovernmental Panel on Climate Change (IPCC) warns of increased flooding, more common wildfires, and stronger hurricane seasons that exceed historical expectations in the near future. (14) As these events take their toll on housing and other physical infrastructure, losses could once again exceed those predicted in financial models.