A team of economists recently analyzed 20 years of peer-reviewed studies on the social cost of carbon, an estimate of damages from climate change. They concluded that the average cost, adjusted with improved methodology, is significantly higher than the U.S. government's most recent figures.
That means greenhouse gas emissions will do more damage in the long run than regulators expect, estimates of which will only grow as tools to measure the link between weather patterns and economic output evolve and as weather-economic interactions increase costs in unpredictable ways.
It's the kind of data that would be expected to sound alarm bells across the financial industry, which closely tracks economic trends that could affect stock and loan portfolios. But even the ripples have been hard to detect.
Indeed, recent news on Wall Street has been all about retreat rather than recommitment to climate goals. Banks and asset managers are withdrawing from international climate alliances, frustrated by their rules. Regional banks are increasing lending to fossil fuel producers. Sustainable investment funds are suffering outflows and many are failing.
So what causes this apparent disconnect? In some cases, it's a classic Prisoner's Dilemma: If companies collectively transition to cleaner energy, a cooler climate in the future would be more beneficial for everyone. But in the short term, each company has its own individual incentives to profit from fossil fuels, making the transition much harder to achieve.
And the financial industry is trying hard to understand what a warming future means for avoiding climate damage to its own operations.
To understand what's going on, put yourself in the shoes of a banker or asset manager.
In 2021, President Biden rejoined the U.S. to the Paris Agreement, financial regulators began issuing reports on the risks that climate change poses to the financial system, an international agreement on financial institutions committed to putting $130 trillion worth of funding into reducing emissions, confident that governments would build the regulatory and financial infrastructure to make these investments profitable, and in 2022 the Inflation Control Act was passed.
Since then, hundreds of billions of dollars have flowed into U.S. renewable energy projects. But they're not a sure thing for the people hired to write investment strategies. Clean-energy stocks have been hit hard by high interest rates and supply-chain disruptions, and offshore wind projects have been canceled. If you bought the biggest solar exchange-traded fund in early 2023, you would have lost about 20% of your money while the rest of the stock market soared.
“When you think about what's the best way to tilt a portfolio toward gains, it's really difficult,” said Derek Schug, head of portfolio management at Kestra Investment Management Inc. “These are probably great investments over a 20-year period, but when it comes to being valued over a one- to three-year period, it's a little difficult for us.”
Some firms have institutional clients, such as public employee pension funds, who want to make climate action part of their investment strategies and are willing to take a short-term hit. But they are not the majority. And over the past few years, many banks and asset managers have shied away from anything with a climate-change label, fearful of losing business from states that dislike climate concerns.
On top of that, the war in Ukraine has undermined the financial case for a rapid energy transition. Artificial intelligence and the drive towards electrification are boosting electricity demand, but renewables are not keeping up. So banks have continued to lend to oil and gas producers, who are making record profits. In his annual letter to shareholders, JPMorgan Chase CEO Jamie Dimon said it would be “naive” to simply cancel oil and gas projects.
All of this is about the relative attractiveness of investments that slow climate change.What about the risks that climate change poses to the finance industry's own investments — more powerful hurricanes, heat waves that cripple power grids, wildfires that devastate cities?
While there is evidence that banks and investors are pricing in some physical risk, it is also clear that much of it remains ignored and lurking.
Over the past year, the Federal Reserve has asked the six largest U.S. banks to study what would happen to their balance sheets if a major hurricane struck the Northeast. A summary last month found that a lack of information on property characteristics, counterparties and especially insurance coverage made it difficult for lenders to assess the impact on loan default rates.
Parinitha Sastry, an assistant professor of finance at Columbia Business School, has studied shaky insurers in states like Florida and found that insurance coverage is often much weaker than it appears, increasing the likelihood of mortgage defaults after a hurricane.
“I am very concerned about this because the insurance market is an opaque weak link,” Dr Sastry said. “There are parallels with the complex nexus that happened in 2008, where a weak and unregulated market spilled over into the banking system.”
Regulators worry that without understanding those ripple effects, a single bank could face problems or even become an epidemic that undermines the financial system. They have set up systems to monitor potential problems, but some financial reformers have criticized them as inadequate.
But while the European Central Bank is considering climate risks in its policy and oversight, the Federal Reserve has resisted playing a more active role, despite signs that extreme weather is stoking inflation and high interest rates are slowing the transition to clean energy.
“The argument goes, 'Unless we can convincingly show that this is part of our mandate, Congress should deal with it, it's none of our business,'” said Johannes Stroebel, a finance professor at New York University's Stern School of Business.
Ultimately, that view may be right: Banks are in the business of managing risk, and as climate forecasting and modeling tools improve, they can stop lending to companies and regions that are clearly at risk. But that will only create more problems for people in those places when credit and business investment dry up.
“We can conclude that this is not a threat to financial stability, but it could still result in significant economic losses,” Dr Stroebel noted.
While it remains difficult to assess where portfolio risks lie, there is also a shorter-term uncertainty looming: the outcome of the US elections, which could determine whether further steps are taken to address climate change concerns or existing efforts are rolled back. An aggressive climate change strategy may not work under a second Trump administration, so it may be wise to wait and see how that plays out.
“Given how the system has moved so far, it's been slow moving so there's still time to get to the other side of the fence, so to speak,” said Nicholas Kodra, senior portfolio manager at Brinker Capital Investments.
John Morton, who served as a climate adviser to Treasury Secretary Janet L. Yellen before rejoining the climate-focused consulting and investment management firm Pollination Group, has observed that big companies are hesitant to make climate-sensitive investments as November approaches, but he says “this assumption is flawed in two ways and is very dangerous.”
First, states such as California are imposing stricter rules on carbon-related financial disclosures that could be further strengthened if the Republicans win, and second, Europe is phasing in a “carbon border adjustment mechanism” that would punish polluting companies that want to do business in Europe.
“Our view is to be careful,” Morton said. “If you're still sitting on a big bag of carbon in 10 years' time, you're going to be at a disadvantage in the marketplace.”
But for now, even European financial institutions are feeling pressure from the United States, which has so far offered some of the most generous subsidies for renewable energy investment but does not impose a carbon price.
Global insurer Allianz has laid out a plan to align its investments in a way that could prevent warming from rising more than 1.5 degrees by the end of the century if all other companies did the same. But it's hard to steer a portfolio toward climate-friendly assets while other funds are taking on polluting companies and making short-term profits for impatient clients.
“The main challenge for asset managers is to really attract clients,” said Markus Zimmer, an economist at Allianz. Asset managers don't have enough leverage to shift money from dirty to clean investments on their own if they want to stay in business, he said.
“Of course it would be helpful if the financial industry was ambitious in some way, but it can't make up for a lack of action from policymakers,” Dr Zimmer added. “In the end, it's very hard to get around it.”
New research shows that the faster we decarbonize, the greater the benefits, because the risk of extreme damage increases over time. But without uniform rules, some will monopolize the short-term benefits and others will be penalized. And in the long term, everyone will lose out.
“The worst case scenario would be if we committed our business model to 1.5°C and then 3°C turns out to be a reality,” Dr Zimmer said.
