There is no denying that climate change is a real phenomenon that is causing extreme weather events like cyclones and prolonged droughts to occur more frequently and with greater intensity. Mass migration, disruption of livelihoods, and infrastructure devastation are the results of these occurrences. Fossil fuel companies and automakers equally acknowledge the necessity of a transition to renewable energy sources and cleaner vehicular technologies, as evidenced by the persistent rise in temperatures, despite ongoing mitigation efforts. The endeavour of quantifying the economic repercussions of climate change remains a difficult one. Traditional economic analyses can quantify the immediate costs associated with changing weather patterns and natural disasters; however, numerous potential costs exceed these limits. A non-linear acceleration of the economic consequences of climate change is anticipated, with future harm being contingent upon current policy decisions.
The financial sector is increasingly acknowledging the significant implications of climate change, which are influenced by two primary channels: physical risks and transition risks. Transition risks are generated by technological advancements, changes in climate policy, and shifting consumer and market sentiments towards a lower-carbon economy, while physical risks entail damage to property, infrastructure, and land. Different countries face different dangers, with lower- and middle-income economies being more susceptible to physical threats. According to the 15th annual Banking on Climate Chaos (BOCC) report, European banks, including Deutsche Bank, Santander, and Barclays, were among the largest financiers of fossil fuels in 2023, despite global commitments to reduce emissions. The report examines the financial operations of the top 60 private banks internationally. It was written by researchers from organizations such as BankTrack and Oil Change International and is supported by almost 600 groups worldwide. It was shown that since the Paris Agreement was signed in 2016, these banks have contributed almost $6.9 trillion (€6.4 trillion) in finance for fossil fuels, with $3.3 trillion (€3 trillion) going towards just the expansion of fossil fuel use.
Major banks financed fossil fuels to the tune of $705 billion (€653 billion) in 2023, with US banks accounting for 30% of the total, headed by JP Morgan Chase. More than 25% of the total came from European banks, with Barclays leading the way, followed by Santander and Deutsche Bank. Even though these banks have pledged to achieve net zero emissions, a sizable amount of their money still goes towards fossil fuel projects. Critically, the report notes that European banks have exhibited a greater willingness to finance LNG and methane gas projects, with a particular disregard for the long-term climate dangers involved. The report scrutinizes the transparency and effectiveness of the banking sector’s decarbonization strategies, observing that, despite the existence of certain restrictions on oil and gas financing, the overall policies are still insufficient. It is important to note that European banks have made some progress in restricting new financing for oil and gas fields. However, there has been no real progress in coal financing or the overall quality of oil and gas policies. The BOCC emphasizes the necessity for banks to develop robust strategies to phase out fossil fuel support and demands for the immediate cessation of financial services to the development of fossil fuels.
The financial sector is exposed to substantial physical risks as a result of climate change. These risks are compounded by investments in companies, households, and nations that are experiencing climatic shocks, as well as from broader economic impacts. These hazards result in a decrease in asset valuations and an increase in default probabilities in loan portfolios. For instance, increasing sea levels and an inclination for extreme weather can result in significant losses for homeowners, which increases the risk associated with mortgage portfolios. Corporate credit portfolios are also susceptible to vulnerability, as exemplified by the bankruptcy of Pacific Gas and Electric, which was precipitated by extended droughts and heightened wildfire risks. The frequency and severity of claims exceed expectations, confronting insurers and reinsurers with risks on both the asset and liability sides. Insurance is becoming increasingly expensive or unavailable in high-risk regions due to the increasing frequency of natural disasters. By increasing the probability of correlated events, such as droughts and floods, climate change also undermines diversification strategies. Financial organisations must therefore include climate risk assessments into their risk management and strategic planning procedures.
Financial institutions face substantial obstacles due to transition risks, especially when they invest in companies that are not well-suited for a low-carbon economy. As the world transitions to low-carbon energy sources, fossil fuel companies may discover that their reserves are “unburnable.” A combination of regulatory initiatives, technical advancements, and climate-conscious stakeholders have resulted in decreased revenues, operational disruptions, and rising funding costs for these firms. The coal industry, which is already impacted by carbon emission policies and reduced financing for new projects, exhibits a “carbon discount” in share prices, resulting in underperformance in comparison to renewable energy assets. If the transition is abrupt, inadequately managed, or lacks global coordination, it disrupts international trade, resulting in broader economic risks. The integrity of financial systems is jeopardized when asset prices abruptly adjust in response to physical risks or unexpected transitions. Asset prices frequently fall short of accurately reflecting the potential harm and necessary policies to keep global warming to 2˚C, despite some market pricing of climate risks. This highlights the possibility of financial instability during the transition to a sustainable economy.
There is a complex and wide-ranging relationship between climate change and the financial industry. The financial sector must adjust to both the immediate physical risks and the long-term transition risks associated with a shift towards a low-carbon economy as the world continues to experience the physical impacts of climate change. Financial institutions’ investment decisions have a significant impact on the exacerbation or mitigation of climate change. They must establish transparent, robust strategies to eliminate fossil fuel financing and promote sustainable initiatives. The future stability of global financial systems and the broader economy is contingent upon the proactive management of these climate-related risks, emphasizing the necessity of forward-thinking policy decisions and coordinated global action.
Raghav Arora, Final Year Student, Rajiv Gandhi National University of Law, Punjab, India
Anwesha Ghosh, Assistant Professor, Rajiv Gandhi National University of Law, Punjab, India