Banks, insurers and asset managers face a growing threat from climate change, as the physical effects of global warming and the transition to a low-carbon economy pose unprecedented risks to the status quo.
Banks have been quick to capitalise on rising demand for sustainable financial products such as green bonds, but slower to account for the danger of stranded assets and mispriced risk on their balance sheets.
The real estate and mortgage markets are an area of particular concern, the McKinsey Global Institute has found. In the US state of Florida alone, McKinsey estimates that increased flood exposure could knock $30bn to $80bn off residential property valuations by 2050.
With increased flood risk and property devaluations comes the danger of mortgage defaults. Many homeowners have no flood insurance and will be exposed. Extreme weather and flooding can also affect people’s livelihoods and ability to get to work and pay their debts.
“You could have a community breakdown and an infrastructure breakdown [where] roads are flooding more,” says Hans Helbekkmo, partner at McKinsey. This also creates a higher chance of “strategic default”, where homeowners walk away from a property once there is a significant fall in the price, he adds.
“The mortgage lending business would want to take a close look at this,” says Mr Helbekkmo. Given that many mortgages are sold to government-sponsored enterprises such as Fannie Mae in the US, “governments could end up holding the bag”.
Banks’ commercial lending arms also face problems because of exposure to coal. The fuel is becoming economically unviable as natural gas and renewable energy prices drop. Yet many banks still lend to coal companies and are in danger of mispricing the risk, says Chris Hohn, the billionaire hedge fund manager.
Sir Chris has launched a campaign to compel lenders to disclose their exposure to coal. “The risk of a coal loan is accounted for by banks and regulators as investment grade, when in fact they are high-risk in nature,” he says. The campaign has threatened legal action if they do not accurately weigh coal risk. “If you falsely mark a loan or risk weighting you can have breach of fiduciary duty.”
Banks including JPMorgan Chase have recently been targeted by environmental activists, which want companies to stop financing fossil fuel and have used tactics from filing shareholder resolutions to protests at bank offices.
Insurers are also exposed, as they may be liable to cover legal penalties against coal companies held responsible for environmental damage, according to a research note by rating agency Moody’s. “Insurers could . . . benefit from reduced exposure to potential environmental liability risks associated with thermal coal industries,” the 2019 note said. More than 1,300 such lawsuits have been brought against companies and governments, according to activist group Unfriend Coal, which aims to make the sector uninsurable. In one instance, American Electric Power said last July that it would retire a 1,300MW unit at its power plant in Rockport, Indiana, to settle a lawsuit over air pollution.
So far a number of insurers have walked away from coal, especially in Europe, including Axa, Zurich and Swiss Re. Beyond fear of lawsuits, they have an incentive to try to mitigate harm of climate change however they can — including making it harder to operate coal-fired power plants.
“As a global insurer we are impacted by climate change, in everything from increasing fire risk to flooding,” Joseph Wayland, general counsel of Chubb, said in July when it became the first large US insurer to stop covering coal companies.
As the climate changes, the data and models used by insurers to set rates “may well prove insufficient over time for the rising levels of risk”, warned McKinsey. The position of participants “from insured to insurer to reinsurer to governments as insurers of last resort”, needed examination, it added.
Insurers also risk losing money on investments if they own shares in fossil fuel companies holding stranded assets. Pension funds, sovereign wealth funds and asset managers are also likely to be affected. As much as $900bn worth of fossil fuel reserves will be written off if governments take action to keep global warming under 1.5C, according to FT estimates in a Lex In Depth report.
Yet stranded asset risk may be the tip of the iceberg for investors. New research from BlackRock, the investment management group, suggests that shifting investor preferences are likely to drive up prices for “sustainable” companies and punish those that perform poorly on environmental, social and governance (ESG) criteria.
They also face mounting pressure from customers and activists to curb money going into fossil fuels, but many investors are hesitant to fully divest. Instead, many large investors are trying to engage with companies to push them to green their operations.
A number of investor groups are banding together to put pressure on boards and chief executives, such as Climate Action 100+, which recently added BlackRock to its roster. The group focuses on big emitters, and has signed up 450 investors with more than $40tn in assets under management. However, the results have not lived up to some activists’ expectations.
“We would celebrate the day the Climate Action 100+ rises to the challenge ahead of us. The initiative has involved a lot of self-congratulation and paper agreements, and it is untied to real-world outcomes,” says Brynn O’Brien, executive director of the Australasian Centre for Corporate Responsibility.
“If it were to rapidly become more ambitious, transparent and consistent, it could be an extremely important initiative.”