Climate change is the greatest challenge of the modern day with the capacity to destabilize global financial systems and socioeconomic welfare. This chapter explores the uncertainties posed by climate change, its effects on the economy, the risks associated with the phenomenon, and approaches to manage them through risk management. Using documented evidence, climate change is shown to result in gross domestic product reductions; physical, transition, and liability risks that result to systemic financial problems characterized by liquidation of companies, losses for, and closure of financial firms and their intermediaries; and inability of investors to pay debts. Climate risk management is proposed as a solution to adapt to climate change and reduce its associated risks.
TopIntroduction
The disturbance in the long-term of normally perceived weather patterns resulting from global warming is commonly referred to us climate change. According to Nyika (2020), the phenomenon is a great impediment to sustainable growth globally. The situation is of great concern among developing countries since their vulnerability is high and their resilience and preparedness are limited due to financial constraints and high poverty levels (Nyika, 2021). According to the Intergovernmental Panel on Climate Change (IPCC) (2018), anthropogenic-based activities have resulted in the warming of planet earth by 1°C above the pre-industrial levels. Consequently, storms, wildfires, droughts, and floods with catastrophic consequences are becoming regular occurrences. Current projections also show that these changes will have dire economic, environmental, and social impacts. A study by Kompas, Pham and Che (2018), for instance, suggested that if temperatures rise 4°C higher compared to pre-industrial levels in the next 8 decades, economic losses around the globe will rise to $ 23 trillion every year and this would result in a crisis worse than the 2007-2008 financial crises globally. The magnitude and speed at which actions are taken to reduce greenhouse gas emissions will influence how much of the impacts of climate change can be overcome in the coming decades if sustainability is to be realized.
Climate change worsens pre-existent risks in addition to creating new ones for human and natural systems (IPCC, 2014). Global risks associated with climate change are highlighted by the World Economic Forum’s Global Risk Report (World Economic Forum, WEF, 2016). In specific, the lax and inability to mitigate and adapt to climate change is ranked in the top five considering that the adverse effects of the phenomenon are systemic and pervasive (Zhao, Yan, Wang, Tang, Wu, Ding & Song, 2018). Besides, they affect all economies, industries, and classes of assets and people resulting in a negative impact on the financial system.
Climate change has severe consequences on financial stability as established in the literature (Aglietta & Espagne, 2016; Batten Sowerbutts & Tanaka, 2016; Scott van Huizen & Jung, 2017; Dafermos, Nikolaidi & Galanis, 2017, 2018). Notable cases that were linked to climate change effects include the bankruptcy of Pacific Gas and Electric (PG and E), which was California's largest electricity producer. In this case, climate change resulted in consumption and production disruptions as well as a reduction of the company's asset value (MacWilliams, LaMonaca & Kobus, 2019). Similarly, the former governor of the Bank of England, Mark Carney suggested that with ample evidence on the threatening nature of climate change, the phenomenon is likely to influence financial stability in the long term (Carney, 2015).