A team of economists recently analyzed 20 years of peer-reviewed research on the social cost of carbon, an estimate of the damage from climate change. They concluded that the average cost, adjusted for improved methods, is significantly higher than even the most recent U.S. government figure.
That means that greenhouse gas emissions will eventually take a greater toll than regulators anticipate. As tools for measuring the links between weather patterns and economic output evolve — and the interactions between weather and the economy magnify costs in unpredictable ways — estimates of the damage have only risen.
It’s the kind of data you’d expect to set off alarm bells in the financial sector, which closely monitors economic developments that could impact equity and loan portfolios. But it was difficult to detect even a ripple.
In fact, the news from Wall Street lately has been about withdrawing climate targets, rather than recommitting. Banks and asset managers are pull back of international climate alliances and to sand by their rules. Regional banks do increasing lending to fossil fuel producers. Have sustainable investment funds paralyzing outflowand many have collapsed.
What explains this apparent discrepancy? In some cases it is a classic prisoner’s dilemma: if companies collectively switch to cleaner energy, everyone will benefit more from a cooler climate in the future. But in the short term, each company has an individual incentive to benefit from fossil fuels, making the transition much more difficult to achieve.
And when it comes to preventing climate damage to their own operations, the financial sector is grappling with the question of what a warming future will mean.
To understand what is going on, you have to put yourself in the shoes of a banker or asset manager.
In 2021, President Biden brought the United States back into the Paris Agreement, and his financial regulators began issuing reports about the risk that climate change posed to the financial system. A global compact of financial institutions has made commitments worth $130 trillion to try to reduce emissions, trusting that governments would create the regulatory and financial infrastructure to make those investments profitable. And in 2022, the Inflation Reduction Act was passed.
Since then, hundreds of billions of dollars have poured into renewable energy projects in the United States. But that doesn’t make them a good choice for people paid to develop investment strategies. Clean energy stocks have been battered by high interest rates and supply chain hiccups that have led to the cancellation of offshore wind projects. If you had bought some of the largest exchange-traded solar funds in early 2023, you would have lost about 20 percent of your money while the rest of the stock market soared.
“When we think about what’s the best way to move your portfolios toward upside, it’s very difficult,” said Derek Schug, head of portfolio management at Kestra Investment Management. “These will probably be great investments over 20 years, but if we are assessed in one to three years, it’s a little more challenging for us.”
Some companies are targeting institutional clients, such as government employee pension funds, that want to combat climate change as part of their investment strategy and are willing to take a short-term hit. But they are not a majority. And over the past few years, many banks and asset managers have shied away from anything with a climate label for fear of losing business from states that frown on such concerns.
Moreover, the war in Ukraine threw the financial case for supporting a rapid energy transition into disarray. Artificial intelligence and the move toward greater electrification are driving greater energy demand, and renewables haven’t stopped there. So banks continued to provide loans to oil and gas producersthat have delivered record profits. Jamie Dimon, the CEO of JPMorgan Chase, said in his annual letter to shareholders that simply halting oil and gas projects would be ‘naive’.
That’s all about the relative attractiveness of investments that would slow climate change. How about the risk that climate change poses to the financial sector’s own investments, through more powerful hurricanes, heat waves that knock out power grids, wildfires that wipe out cities?
There are indications that banks and investors include some physical risk in the price, but also that much of it still lurks and goes unnoticed.
Over the past year, the Federal Reserve has asked the nation’s six largest banks to examine what would happen to their balance sheets if a major hurricane struck the Northeast. A resume last month reported that institutions found it difficult to assess the impact on loan default rates due to a lack of information on the characteristics of properties, their counterparties and, most importantly, insurance coverage.
Parinitha Sastry, assistant professor of finance at Columbia Business School, studied wavering insurers in states like Florida and found that coverage was often much weaker than it seemed, increasing the likelihood of mortgage defaults after hurricanes.
“I’m very concerned about this because the insurance markets are this opaque weak link,” Dr. Sastry said. “There are parallels with some of the complex relationships that happened in 2008, where there was a weak and unregulated market that spilled over into the banking system.”
Regulators are concerned that a failure to understand these ripple effects could not only land one bank in trouble, but could even become a contagion that would undermine the financial system. They have setting up systems to monitor potential problems faced by some financial reformers criticized as inadequate.
But while the European Central Bank has done so climate risk created As a consideration in its policy and supervision, the Federal Reserve has resisted taking a more active role, despite evidence that extreme weather is fueling inflation and that high interest rates are slowing the clean energy transition.
“The argument was, ‘Unless we can convincingly demonstrate that it’s part of our mandate, Congress has to deal with it, it’s none of our business,’” said Johannes Stroebel, professor of finance at the University’s Stern School of Business of New York.
Ultimately, that view may be right. Banks are managing risk, and as climate forecasting and modeling tools improve, they can stop lending to companies and places that are clearly at risk. But that only creates more problems for the people in those places as credit and business investment dries up.
“You can conclude that it does not pose a threat to financial stability, and there could still be large economic losses,” noted Dr. Trouble on.
While it remains difficult to assess where the risks lie in one’s portfolio, a much shorter-term uncertainty looms: the outcome of the US election, which could determine whether further action is taken to address climate concerns or existing efforts are reversed. An aggressive climate strategy may not fare as well during a second Trump administration, so it may seem wise to wait and see how it plays out.
“Given the way our system has evolved so far, it’s moving so slowly that there’s still time to get to the other side of the proverbial fence,” said Nicholas Codola, a senior portfolio manager at Brinker Capital Investments.
John Morton was a climate adviser to Treasury Secretary Janet L. Yellen before rejoining the Pollination Group, a climate-focused advisory and investment management firm. He has noted that large companies are hesitant about climate-sensitive investments as November approaches, but says “two things are misplaced and quite dangerous about this hypothesis.”
One: States like California are setting up stricter rules for carbon-related financial disclosures and could ramp this up further if Republicans win. And two, Europe is in the process of introducing a “carbon border adjustment mechanism,” which will punish polluting companies that want to do business there.
“We believe you have to be careful,” Mr. Morton said. “You’re going to be at a disadvantage in the marketplace if you’re left with a big bag of carbon in 10 years.”
But now even European financial institutions are feeling pressure from the United States, which – while providing some of the most generous subsidies yet for renewable energy investments – has failed to put a price on carbon.
Global insurance company Allianz has a plan in place to do just that coordinate its investments in a way that would prevent warming of more than 1.5 degrees Celsius by the end of the century, if everyone else did the same. But it’s difficult to steer a portfolio toward climate-friendly assets while other funds battle polluting companies and rake in short-term profits for impatient clients.
“This is the biggest challenge for an asset manager, to really get the client on board,” said Markus Zimmer, economist at Allianz. Asset managers themselves do not have enough tools to take money out of polluting investments and invest in clean ones if they want to stay in business, he said.
“Of course it helps if the financial sector is ambitious in some way, but you can’t really replace the lack of action from policymakers,” added Dr. Zimmer. “At the end of the day, it’s very hard to get around it.”
According to new researchThe benefit is greater if decarbonization happens faster, because the risks of extreme harm increase over time. But without a uniform set of rules, someone will reap the immediate benefits, hurting those who don’t — and the long-term outcome is bad for everyone.
“The worst thing is if you set your business model to 1.5 degrees of compliance and three degrees are achieved,” said Dr. Zimmer.
