16 November 2018

Mark Sanders on the NRC climate blog

Climate change might see our savings dwindle

Banks and pension funds are still not taking sufficient account of the risks of climate change, writes Mark Sanders, Associate Professor in Economics of Transition and Sustainability at Utrecht University and member of the Sustainable Finance Lab.

This blog was published on 10 October 2018 on the climate blog of the NRC.

With the Paris climate goals, we have set ourselves ambitious technical but, even more so, economic and political challenges. As an economist, I particularly see us facing enormous investments and, therefore, a role set aside for the financial industry. Many larger and smaller players in the financial industry underwrite the Paris goals and claim to be willing to take up their responsibility. Forerunners are moving away from coal (like the PME Pension Fund) and using their client network to put energy efficiency on the agenda (like ABN-Amro Bank).

The supervising bodies have also woken up. Last spring, for instance, Klaas Knot, president of the Bank of the Netherlands, stated in a speech:

“Because climate-related topics can affect the solidity of financial institutions, they should be a focal point for both banks and supervising bodies."

However, there is still a huge gap between ‘want’ and ‘can’. What is missing, is a workable quantification of transition and climate risks. It would help if the financial industry were to determine that there are just two scenarios for them to consider. We have the Paris scenario, in which we start and step up the energy transition and achieve the ambitious objectives to limit climate change. In this scenario, businesses, citizens and financial institutions run major transition risks.

Then there is the non-Paris scenario, in which we fail in the quest and climate change will have disastrous consequences. In this scenario, the same businesses, citizens and financial institutions run big transition risks. That’s it - these are the only options on the table.

Transition risks

The transition risks are the risks we run in a world that transitions successfully. On a macro scale, this scenario is eminently preferable. The costs are high, but they pale in comparison with the amount of damage to the climate that we would manage to prevent.

This macro picture is irrelevant to businesses, civilians and their financiers, however. What is important to them is the risk of businesses and securities decreasing in value during the transition. An obvious example are the balance sheets of oil, gas and coal companies. In a successful transition, the vast supplies of oil, gas and coal will remain in the ground – instead of on the energy companies’ balance sheets. This will already be a serious setback in and of itself – the European banks, insurers and pension funds are spending some 350-400 billion in investments directly related to the recovery of oil, gas and coal (see Weyzig et al. 2014), not to mention the factories and transport industry that heavily rely on fossil fuel. From refineries to central heating to specialised mechanics in the car service centre: in a transition, they will all lose value at double speed.

This destruction of capital has to be reflected somewhere in the balance sheet.

In a successful transition, the vast supplies of oil, gas and coal will remain in the ground – instead of on the energy companies’ balance sheets.
Mark Sanders
Associate Professor in Economics of Transition and Sustainability

Climate risks

The alternative to the Paris scenario is not, as many financial parties implicitly presume, to simply continue with the carbon monoxide economy as before. If we do not achieve the Paris goals, we will have to accept huge damages in other respects, for in a non-Paris scenario we will be dealing with more extreme and volatile weather, floods, droughts and storms. That would also affect the balance sheets of the businesses and citizens who finance our financial institutions.

Insurers and reinsurers are already feeling the pressure. However, the consequences for banks and pension funds might also be tremendous. They hold enormous mortgage portfolios, with the property’s value as collateral. Should this property suffer damage from floods and storms, this might affect the stability of the financial system.

Heat and droughts may have a lesser effect on the value of property, but they do have an impact on agricultural productivity and healthcare costs. Moreover, since climate change does not simply happen to hit a house or company here or there but wreaks havoc in entire regions, countries and continents, traditional diversification offers no relief.

There is little room for climate risks in the current risk models. This is partly because supervising bodies haven't asked for it (yet), and partly because banks and pension funds simply do not yet know how to quantify these risks. This makes research into the financial risks of climate change and the energy transition extremely urgent.

Supervising bodies like the Bank of the Netherlands and the Bank of England have already started to look into it, but the industry itself will also have to spring into action soon. Only then will these risks become items in the balance sheets of the financial industry and will they motivate businesses to also change their behaviour. One thing is certain: transition or not; there will be no such thing as ‘business as usual’ when it comes to our savings in the coming years.

Scientists from Utrecht University are reporting in the climate blog of the NRC on their research in the field of sustainability. They are united around the strategic theme of 'Pathways to Sustainability'.