The financial risks from climate change
Climate change is another catastrophe on the horizon and African countries are not prepared for the consequences
As the spread of Covid-19 was slowly taking hold in April 2020, a systemic risk was developing in financial markets, imperilling the stability of the global economic and financial system.
It started with large and small companies struggling with increased outflows because of the pandemic-induced panic, which meant they had to resort to bank funding. Banks, faced with large-scale demands for credit, were in turn forced to tap into their liquidity buffers – a regulatory cash cushion that is set aside for financial crises. Many global institutions had to activate their emergency liquidity plans.
As the crisis continued, investor appetite started to shift to (“less risky”) US dollars - so called flight to quality. It meant investors, seeking safe haven assets were dashing for dollars and dollar-denominated securities, further exacerbating the liquidity crisis. This led to a negative impact on flow of funding between banks and ultimately the flow of credit to people and businesses was draining up.
When governments started to impose lockdowns, the livelihoods of millions of people were impacted and credit default risk was another major concern. Banks, already struggling with liquidity, risked being overwhelmed by a capital problem from taking in potential losses from customers defaulting after losing their jobs. As a consequence, they stopped lending to reduce their exposures, putting the viability of many good businesses at risk. The more businesses closed down, the more job losses increased.
"Climate change risk is long-term and its effects are slow-moving which accumulate over decades. By the time risks crystallise, mitigation plans are futile. The erroneous assumption that climate change is tomorrow’s problem, rather than today’s existential threat, eats away at the urgency to recognise this risk. This is a costly strategic mistake."
The trillion-dollars stimuli we had seen in rich countries that pumped cheap liquidity into the financial system and businesses, and funded job-retention schemes, effectively nationalised financial risks. In rich economies, millions of jobs were saved, restoring market confidence and avoiding large-scale economic and financial system fall-out. In financial markets parlance, the stimulus packages in these countries averted what would have been an economically and financially destructive “domino effect”.
This context is important and helps to explain how, the Coronavirus, in essence a public health issue, was crippling economic and financial activities on a global scale. More importantly, it is also precisely why this global pandemic holds important lessons for the other much more serious catastrophe on the horizon: climate change.
Much bigger in impact and scale
African countries do not have the monetary and fiscal flexibilities needed to deal with Covid-19 and are therefore forced to make painful trade-offs between saving lives and supporting economic recovery, thereby prolonging the crisis. Many economies, already weakened by low growth, political instability and geopolitical risks, will be caught in a financial long-Covid and operate well below their capacities for many years, even if governments eventually succeed in containing the virus. Sustained reduced economic output reverses progress and threatens long-term investment and job creation opportunities. The longer this goes on, the larger will the impact on a country’s future prosperity.
Covid-19 and climate change have one thing in common: both are global in impact and scale. However, whilst the consequences from Covid-19 can be mitigated to a degree, the impact from climate change is irreversible. Climate change risk is long-term and its effects are slow-moving which accumulate over decades. By the time risks crystallise, mitigation plans are futile. The erroneous assumption that climate change is tomorrow’s problem, rather than today’s existential threat, eats away at the urgency to recognise this risk. This is a costly strategic mistake.
The financial risks from climate change broadly fall into two categories: transition risks which happen as a country moves away from high-carbon into low-carbon economy which could have negative implications for jobs and investments in particular sectors of the economy; and the physical effects from climate change such as droughts, heatwaves, floods, fires and storms.
For many African countries, it is the physical risks from weather-related events that will have the most material impact. Severe climatic changes that result in flooding, prolonged droughts – as is the case in many parts of Africa -, heatwaves or plagues, such as the plague of locusts that devastated East Africa in 2019 and 2020, will create significant losses, financial and economic disruption on a much larger scale.
Take two key examples: If a country faces large-scale flooding, hurricanes or wildfires, resulting in the destruction of critical economic infrastructures, (such as roads, bridges, powerplants, factories), the government could find itself unable to raise investment funding because of elevated sovereign default risks. Food insecurity will become another issue as arable land becomes scarce and a government’s fiscal headroom is depleted on imports of basic necessities. Displacement of large people from impacted areas will create new demands on governments and flame geopolitical tensions between countries and within communities. Governments would be forced to prioritise ever-increasing expenditure on basic survival, while much needed investment in human and economic infrastructure and development will disappear altogether.
Companies exposed to climatic risks will also see the value of their key assets – land, buildings, plant and equipment, impaired and struggle to raise investment, or lose the ability to use these assets as collateral, which in turn will impact job creation, hampering long-term economic prosperity and reducing government’s tax revenues.
The balance sheet of insurance and financial services firms will also be severely impacted as the values of financial assets decline and insurance risks increase materially. Bank assets, including collateral, that decline in value will hit bank balance sheets, eroding capital and leading to insolvencies. Banks and investors could stop funding areas or countries deemed to be significantly exposed to climatic risks, leading to a narrowing of the financial risk appetite for large geographies.
The human cost of this is also incalculable as people lose their homes and livelihoods because of climatic events and the impact of this gets amplified throughout the economy and financial system.
Thinking about these existential challenges
Mitigating the harm from climate change will require a combination of clear political thinking, country-specific mitigation plans and continent-wide strategic approach to policymaking.
First, the pace of disruptive technologies, investor sentiment and wider societal preferences are driving global efforts to deal with transition risks. It is therefore important African countries are clear-eyed about these transition risks and steer foreign direct investments into sustainable economic sectors, including renewables.
Second, the considerable trillion-dollars price tag of climate change mitigation is beyond the capabilities of African economies. Overreliance on development institutions, whose core priority is help deal with past events, rather than prepare for tomorrow’s catastrophes, is not be a viable option. This is why the continent needs an “African Central Bank” that can lead policy development in this area, create a new landscape for liquidity and capital market funding opportunities and support financial system adjustment. African Central Banks should start to stress test banks and insurance companies in order to assess the adequacy of their resilience against idiosyncratic and system-wide climatic risks and vulnerabilities.
We don’t have the luxury to ignore this risk. Recognising and understanding what this means for people’s lives and livelihoods will indeed be the first important challenge for any responsible government.
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A version of this analysis piece written by Abdi Ali was first published in the Africa Briefing Magazine in July 2021. https://africabriefing.org/magazine-july-august-2021/
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