Global warming: The Bank of England has its say ….

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We generally expect central bank governors to talk about economic fundamentals, money supply expansion or interest-rate policy. If the governor of the Bank of England feels the need to express an opinion on climate change, it is obviously not to lament the decline in the numbers of polar bears or to sound the alarm on projections of heavier alcohol content in fine Bordeaux wines.

Instead, Mark Carney sought to alert the financial community to the risks that global warming is creating for insurance companies, asset owners and, more broadly, all economic actors. These risks encompass extreme weather events, water and food supplies, geopolitical instability, migrant flows and long-term asset viability.

Unknown fallout

Despite the protests of some strident climate sceptics, it now appears certain that global warming will generate unprecedented risks affecting economic activities in various parts of the world. These risks are hard to assess since they represent a huge unknown that is facing humanity and, as a corollary, involve the statistical unpredictability of pinpointing their effects in time and space.

Here is what we do know

What we do know with almost perfect clarity is:

1) these effects will play out over the very long term in a creeping, unexpected and even violent manner
2) future generations will have to bear their costs
3) there is little point in trying to quantifying those costs right now.

Now, the effects of global warming are still slight and superficial, but they involve risks that go well beyond the monetary policy cycle (about three years), the normal business cycle (about 10 years) and the cycle of replacing a generation of political leaders.

Do we need to take action now?

And there’s the rub – a terrible existential duality. On the one hand, the urgency to act to save long-term interests from an implacable danger that has not yet materialised and that most still consider to be hypothetical. On the other hand, there is opposition to acting now to preserve current comforts and self-thinking habits – already acquired by some people and desired by others. This is what Mark Carney, the Bank of England Governor, calls “the tragedy of the horizon”.

But once the most serious consequences of global warming are there to see, its inertia will be such that it will be too late to do anything about it. The earlier action is taken to limit its impact, the less serious its damage and the lower the costs of acting should be. Some have even suggested that failure to act is criminal.

Global warming and instability

In particular, Mark Carney stressed the financial instability that would be inevitable in the event that the phenomenon accelerates. He has identified three classes of risk:

1) Physical risks. For example, increasingly frequent flooding and hurricanes in many regions are causing direct harm to personal and business property; in some cases, they also destroy the transport links that are essential for trading of goods. Moreover, experts believe that a disruption in climate could trigger a resumption in pandemics, which are currently somewhat under control. This would affect insurers of all these risks and we are just now glimpsing the harbingers.

2) Liability risks. In the future, those suffering climate change losses may seek compensation from parties they hold accountable. These parties will probably be hard to identify precisely, but some will be blamed more than others, such as companies that manage or finance coal-fired power plants. More generally, the blame could be put on companies or individuals whose activities and liabilities have contributed to climate change, those who did not have an aggressive policy to offset their carbon footprints, those who did not accurately assess the risks incurred or those who were not subject to regulations.

3) Financial risks. Shifts in public policies, technological disruptions transitioning to the brave new “low-carbon” world and extreme weather events in parts of the world will mean revisiting the valuations assigned to certain assets. Unexpected costs or hidden opportunities will naturally emerge. For example, under a best-case carbon budget limiting an increase in temperatures to less than 2°C (compared to the pre-industrial era) – the Cancun Agreement in 2010 committed governments to “hold the increase in global average temperature below two degrees” as two degrees has been suggested as the point beyond which the damage caused by climate change may become non-linear – a substantial portion of oil and gas reserves will become ‘stranded’. Accordingly, oil companies are probably currently overvalued. These financial adjustment risks will obviously be lower if the energy transition begins now and sticks to a clearly defined medium- and long-term path.

Transparency and consistency in public policies will be essential factors in allowing financial markets to anticipate future developments and allocate the necessary capital effectively. Any sudden upheaval in asset valuations could be the source of persistent financial instability and a deterioration in financing conditions.

This need for transparency also applies to the companies themselves. Lawmakers will have to be familiar with the tangible state of affairs (among others, CO2 emissions by sector and by technology, impacts on profitability) and will have to ensure the quality of legal texts that will frame public action. And the carbon market will have to function properly and be able to effectively allocate the capital that the economy needs to best rise to the challenge of the energy transition. Based on the saying “what gets measured gets managed”, a normative structure of measuring the carbon footprint will probably be required for purposes of analysis and comparison.

Insurers in the frontline

Insurance companies will likely be the first ones affected by the emergence of these risks. They will first have to blindly estimate the insurance premiums applicable and will then probably have to raise some of them sharply. Coverage of some risks may have to be spread out more broadly under state supervision or even be nationalised outright.

Global warming and investment opportunities

Like insurance companies, all companies, in fact, must quickly:

1) understand the nature of their activities as measured by their carbon footprint
2) determine how global warming will transform those activities’ prospects
3) take necessary action to gain market share in fast-expanding sectors (e.g., energy and waste management) or, in the case of other sectors, adapt as best as they can to a world in upheaval.

It is precisely in companies that are able to properly assess the coming changes that BNP Paribas Investment Partners’ environmental funds are investing.

Image: Bank of England, London
Source for the image: ChameleonsEye / Shutterstock.com
Alexandre Jeanblanc

Investment Specialist, SRI

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