Climate change and finance

Climate change is a systematic risk

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In the standard theory of portfolio diversification, we divide risk into systematic and idiosyncratic or diversifiable risk. We argue that idiosyncratic risks can be diversified away, so there is no market reward for bearing such risks. 

But there remain undiversifiable or systematic risks, for which investors should receive some compensation for bearing them, if they choose to own equities. 

Climate change is a systematic risk. The forecast consequences of higher temperatures include: 

1. More frequent or more serious natural disasters such as hurricanes 

2. More volatility in rainfall: sometimes too much, sometimes too little, with greater severity 

3. Lower crop yields on average arising from higher temperatures and the greater volatility of rainfall 

4. Rising sea levels and greater ocean acidification  

5. Glacial retreat, land and forest degradation, loss of biodiversity and desertification.  

It is possible that some regions will benefit from higher crop yields at least for a while, arising from a longer growing season and higher CO₂. But these are likely to be heavily outweighed by costs and damage. 

So what does this mean for the financial system?  

Well firstly it represents a set of risks to existing and future assets, which may not be fully priced in. Insurance companies are already reacting to climate change in respect of wildfire and flooding risks. There is also some evidence that real estate markets are beginning to price the greater risk of some properties, especially coastal real estate. 

These risks cannot be diversified. Individual investors can avoid some of the higher risk assets and regions, many of which are already poorer parts of the world that get little from the global financial system as it is. 

But there is an opportunity too. For climate change effects to be reduced, compared with what they would otherwise be, there needs to be a substantial increase in investment in mitigation: this means chiefly ways of supplying energy that do not depend on fossil fuels, and then on ways of using that energy, which will be increasingly in the form of electricity. 

Much of this is already happening in the form of rapid increases in renewable energy generation capacity, mainly solar panels and wind turbines. There is also a lot of investment going into the electrification of cars. 

But much more needs to be done. The scale of the investment, which is $3.5 trillion a year according to the International Energy Agency, can only be met by harnessing private sector finance. This is far beyond the scope of public sector investment, though that has a role to play. 

There is already a lot of venture capital investment too going into other less proven technologies, such as how to produce cement without generating CO₂. ¹

So if we are to make progress in curbing the production of greenhouse gases and therefore the rise in global temperatures, the financial system is going to be an essential part of the solution. 

Finance isn’t always useful, but in this case it can and must be a key part of the fight to protect the earth, and especially poorer parts of it, from avoidable harm. 

1. I strongly recommend David Roberts’ Volts podcast, which includes interviews with pioneers in developing solutions to the so-called “hard to decarbonise” sectors such as cement manufacture. ↩︎