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Loss and Damage’ from climate change according to Carney

By: Chris Anderson 30/09/2015 Bank of England abridged by 4C Offshore

General

The tragedy of the horizon

Mark Carney's speech addressing an audience of insurers, underwriters and loss adjusters last night is abridged here:-

"There is a growing international consensus that climate change is unequivocal.

Many of the changes in our world since the 1950s are without precedent: not merely over decades but over millennia.

Research tells us with a high degree of confidence that:

In the Northern Hemisphere the last 30 years have been the warmest since Anglo-Saxon times; indeed, eight of the ten warmest years on record in the UK have occurred since 2002; Atmospheric concentrations of greenhouse gases are at levels not seen in 800,000 years; and The rate of sea level rise is quicker now than at any time over the last 2 millennia.

Human drivers are judged extremely likely to have been the dominant cause of global warming since the mid-20th century. The underlying human-induced warming trend of two-tenths of a degree per decade has continued unabated since the 1970s.

Since the 1980s the number of registered weather-related loss events has tripled; and Inflation-adjusted insurance losses from these events have increased from an annual average of around $10bn in the 1980s to around $50bn over the past decade.

The challenges currently posed by climate change pale in significance compared with what might come. The far-sighted amongst you are anticipating broader global impacts on property, migration and political stability, as well as food and water security.

So why isn’t more being done to address it?

A classic problem in environmental economics is the tragedy of the commons. The solution to it lies in property rights and supply management.

Climate change is the Tragedy of the Horizon.

We don’t need an army of actuaries to tell us that the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors – imposing a cost on future generations that the current generation has no direct incentive to fix.

That means beyond:

the business cycle;
the political cycle; and
the horizon of technocratic authorities, like central banks, who are bound by their mandates.

Once climate change becomes a defining issue for financial stability, it may already be too late.
As risks are a function of cumulative emissions, earlier action will mean less costly adjustment.

The desirability of restricting climate change to 2 degrees above pre-industrial levels leads to the notion of a carbon ‘budget’, an assessment of the amount of emissions the world can ‘afford’.

Such a budget highlights the consequences of inaction today for the scale of reaction required tomorrow.

As Chair of the FSB I hosted a meeting last week where the private and public sectors discussed the current and prospective financial stability risks from climate change and what might be done to mitigate them.

I want to share some thoughts on the way forward after providing some context beginning with lessons from the insurance sector.

Climate change and financial stability

There are three broad channels through which climate change can affect financial stability:

- First, physical risks: the impacts today on insurance liabilities and the value of financial assets that arise from climate- and weather-related events, such as floods and storms that damage property or disrupt trade;

- Second, liability risks: the impacts that could arise tomorrow if parties who have suffered loss or damage from the effects of climate change seek compensation from those they hold responsible. Such claims could come decades in the future;

- Finally, transition risks: the financial risks which could result from the process of adjustment towards a lower-carbon economy. Changes in policy, technology and physical risks could prompt a reassessment of the value of a large range of assets as costs and opportunities become apparent.

Risks to financial stability will be minimised if the transition begins early and follows a predictable path, thereby helping the market anticipate the transition to a 2 degree world.

The PRA has worked with regulated firms to produce for the Department for Environment, Food and Rural Affairs a review into the impact of climate change on British insurers.

The Report concludes that insurers stand exposed to each of the three types of risk climate change poses to finance. Longer term risks could have severe impacts on you and your policyholders.

The insurance response to climate change

It stands to reason that general insurers are the most directly exposed to such losses.

Potential increases in the frequency or severity of extreme weather events driven by climate change could mean longer and stronger heat waves; the intensification of droughts; and a greater number of severe storms.

We can expect at least a further 10% increase in rainfall during future winters.

The direct costs of climate change are already affecting insurers’ underwriting strategies and accounts.

For example, work done here at Lloyd’s of London estimated that the 20cm rise in sea-level at the tip of Manhattan since the 1950s, when all other factors are held constant, increased insured losses from Superstorm Sandy by 30% in New York alone.

Lloyd’s underwriters were the first to use storm records to mesh natural science with finance in order to analyse changing weather patterns. Events like Hurricanes Andrew, Katrina and Ike have helped advance catastrophe risk modelling and provisioning. Today Lloyd’s underwriters are required to consider climate change explicitly in their business plans and underwriting models.

But further ahead, increasing levels of physical risk due to climate change could present significant challenges to general insurance business models.

Improvements in risk modelling must be unrelenting as loss frequency and severity shifts with:

Insurance extending into new markets not covered by existing models;
Previously unanticipated risks coming to the fore; and
Increasingly volatile weather trends and hydrological cycles making the future ever-harder to predict.

Absent actions to mitigate climate change, policyholders will also feel the impact as pricing adjusts and cover is withdrawn.

The passage of time may also reveal risks that even the most advanced models are not able to predict, such as third party liability risks.

Claims on third-party liability insurance – in classes like public liability, directors’ and officers’ and professional indemnity - could be brought if those who have suffered losses show that insured parties have failed to mitigate risks to the climate; failed to account for the damage they cause to the environment; or failed to comply with regulations.

Cases like Arch Coal and Peabody Energy – where it is alleged that the directors of corporate pension schemes failed in their fiduciary duties by not considering financial risks driven at least in part by climate change – illustrate the potential for long-tail risks to be significant, uncertain and non-linear.

And ‘Loss and Damage’ from climate change – and what to do about it – is now formally on the agenda of the United Nations Framework Convention on Climate Change, with some talking openly about the case for compensation.

Physical risks from climate change will also become increasingly relevant to the asset side of insurer’s balance sheets.

While the ability to re-price or withdraw cover mitigates some risk to an insurer, as climate change progresses, insurers need to be wary of cognitive dissonance within their organisations whereby prudent decisions by underwriters lead to falls in the value of properties held by the firm’s asset managers. This highlights the transition risk from climate change.

Transition risks

Oil, gas and coal that will be literally unburnable

The UK insurance sector manages almost £2tn in assets to match liabilities that often span decades. While a given physical manifestation of climate change – a flood or storm – may not directly affect a corporate bond’s value, policy action to promote the transition towards a low-carbon economy could spark a fundamental reassessment.

Take, for example, the IPCC’s estimate of a carbon budget that would likely limit global temperature rises to 2 degrees above pre-industrial levels.

That budget amounts to between 1/5th and 1/3rd world’s proven reserves of oil, gas and coal.

If that estimate is even approximately correct it would render the vast majority of reserves “stranded” – oil, gas and coal that will be literally unburnable without expensive carbon capture technology, which itself alters fossil fuel economics.

“green” finance cannot conceivably remain a niche

The exposure of UK investors, including insurance companies, to these shifts is potentially huge.

19% of FTSE 100 companies are in natural resource and extraction sectors; and a further 11% by value are in power utilities, chemicals, construction and industrial goods sectors. Globally, these two tiers of companies between them account for around one third of equity and fixed income assets.

On the other hand, financing the de-carbonisation of our economy is a major opportunity for insurers as long-term investors. It implies a sweeping reallocation of resources and a technological revolution, with investment in long-term infrastructure assets at roughly quadruple the present rate.

For this to happen, “green” finance cannot conceivably remain a niche interest over the medium term.

There are a number of factors which could influence the speed of transition to a low carbon economy including public policy, technology, investor preferences and physical events.

A wholesale reassessment of prospects, especially if it were to occur suddenly, could potentially destabilise markets, spark a pro-cyclical crystallisation of losses and a persistent tightening of financial conditions.

In other words, an abrupt resolution of the tragedy of horizons is in itself a financial stability risk.

The more we invest with foresight; the less we will regret in hindsight.

And there are ways to make that more likely.

Financial policy implications

Financial policymakers will not drive the transition to a low-carbon economy, that is for governments to decide.

But the risks that I have outlined mean financial policymakers do, however, have a clear interest in ensuring the financial system is resilient to any transition hastened by those decisions, and that it can finance the transition efficiently.

Some have suggested we ought to accelerate the financing of a low carbon economy by adjusting the capital regime for banks and insurers. That is flawed. History shows the danger of attempting to use such changes in prudential rules – designed to protect financial stability – for other ends.

More properly our role can be in developing the frameworks that help the market itself to adjust efficiently.

Any efficient market reaction to climate change risks as well as the technologies and policies to address them must be founded on transparency of information.

A ‘market’ in the transition to a 2 degree world can be built. It has the potential to pull forward adjustment – but only if information is available and crucially if the policy responses of governments and the technological breakthroughs of the private sector are credible.

That is why, following our discussions at the FSB last week, we are considering recommending to the G20 summit that more be done to develop consistent, comparable, reliable and clear disclosure around the carbon intensity of different assets.

Better information to allow investors to take a view
Information about the carbon intensity of investments allows investors to assess risks to companies’ business models and to express their views in the market.

By analogy, a framework for firms to publish information about their climate change footprint, and how they manage their risks and prepare (or not) for a 2 degree world, could encourage a virtuous circle of analyst demand and greater use by investors in their decision making. It would also improve policymaker understanding of the sources of CO2 and corporate preparedness.

A carbon budget is hugely valuable, but can only really be brought to life by disclosure, giving policymakers the context they need to make choices, and firms and investors the ability to anticipate and respond to those choices.

Some might dispute the calculations. Others might despair that there will never be financial consequences of burning fossil fuels. Still others could take a view that the stakes make political action inevitable.

The right information allows sceptics and evangelists alike to back their convictions with their capital.

It will reveal how the valuations of companies that produce and use fossil fuels might change over time.

It will expose the likely future cost of doing business, paying for emissions, changing processes to avoid those charges, and tighter regulation.

It will help smooth price adjustments as opinions change, rather than concentrating them at a single climate “Minsky moment”.

Crucially, it would also allow feedback between the market and policymaking, making climate policy a bit more like monetary policy.

Policymakers could learn from markets’ reactions and refine their stance, with better information allowing more informed reactions, and supporting better policy decisions including on targets and instruments.

A climate disclosure task force
That better information – about the costs, opportunities and risks created by climate change and there are already nearly 400 initiatives to provide such information.

Existing schemes vary in their status (from laws to voluntary guidance); scope (from greenhouse gas emissions to broader environmental risks); and ambition (from simple disclosure to full explanations of mitigation and divestment strategies).

In aggregate over 90% of FTSE 100 firms and 80% of Fortune Global 500 firms participate in these various initiatives. For instance, the Carbon Disclosure Project makes available disclosure from 5,000 companies to investment managers responsible for over $90 trillion of assets.

The existing surfeit of existing schemes and fragmented disclosures means a risk of getting “lost in the right direction”.

In any field, financial, scientific or other, the most effective disclosures are:

Consistent - in scope and objective across the relevant industries and sectors;
Comparable - to allow investors to assess peers and aggregate risks;
Reliable - to ensure users can trust data;
Clear - presented in a way that makes complex information understandable; and
Efficient - minimising costs and burdens while maximising benefits.

One idea is to establish an industry-led group, a Climate Disclosure Task Force, to design and deliver a voluntary standard for disclosure by those companies that produce or emit carbon.

Companies would disclose not only what they are emitting today, but how they plan their transition to the net-zero world of the future. The G20 – whose member states account for around 85% of global emissions 28 – has a unique ability to make this possible.

This kind of proposal takes its lead from the FSB’s successful catalysing of improved disclosure by the world’s largest banks following the financial crisis, via the Enhanced Disclosure Task Force (EDTF).

The EDTF’s recommendations, published in October 2012, were the product of collaboration between banks, analysts and investors. This has given the providers of capital the disclosures they need – specifically how banks manage risks and make profits – in a format that the banks can readily supply.

That shows that private industry can improve disclosure and build market discipline without the need for detailed or costly regulatory interventions.

Complementing static disclosures
Static disclosure is a necessary first step. There are two ways its impact could be amplified.

First, governments, potentially sparked by COP21, could complement disclosure by giving guidance on possible carbon price paths.

Such a carbon price corridor involves an indicative minimum and maximum price for carbon, calibrated to reflect both price and non-price policy actions, and increasing over time until the price converges towards the level required to offset fully the externality.

Even if the initial indicative price is set far below the “true” cost of carbon, the price signal itself holds great power. It would link climate exposures to a monetary value and provide a perspective on the potential impacts of future policy changes on asset values and business models.

Second, stress testing could be used to profile the size of the skews from climate change to the returns of various businesses.

This stress-testing technology is well-suited to analysing tail risks likely to grow fatter with time, casting light on the future implications of environmental exposures embedded in a wide range of firms and investments.

Stress testing, built off better disclosure and a price corridor, could act as a time machine, shining a light not just on today’s risks, but on those that may otherwise lurk in the darkness for years to come.

Conclusion

Our societies face a series of profound environmental and social challenges.

The combination of the weight of scientific evidence and the dynamics of the financial system suggest that, in the fullness of time, climate change will threaten financial resilience and longer-term prosperity.

While there is still time to act, the window of opportunity is finite and shrinking.

Others will need to learn from Lloyd’s example in combining data, technology and expert judgment to measure and manage risks.

The December meetings in Paris will work towards plans to curb carbon emissions and encourage the funding of new technologies.

We will need the market to work alongside in order to maximise their impact.

With better information as a foundation, we can build a virtuous circle of better understanding of tomorrow’s risks, better pricing for investors, better decisions by policymakers, and a smoother transition to a lower-carbon economy.

By managing what gets measured, we can break the Tragedy of the Horizon.

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Loss and Damage’ from climate change according to Carney

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