Climate change presents physical risks, including diving asset prices, and transition risks, report finds

Physical risks posed to financial stability by climate change – even in the short term – include a sharp fall in assets prices and an increase in uncertainty, according to a new report issued Monday by an international group of financial regulators.

However, the group said, another key risk to financial stability could be a disorderly transition to a low-carbon economy, brought about by an “abrupt change in (actual or expected” public policy not anticipated by market participants, including that due to the increased materialisation of physical risks, as well as technological developments.”

The report – “The Implications of Climate Change for Financial Stability” – was released by the Financial Stability Board (FSB), a Basel, Switzerland-based organization made up of national authorities responsible for financial stability in 24 countries and jurisdictions, international financial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts.

The report states that financial stability risk from climate change comes in two flavors: physical and transition risks. “The value of financial assets/liabilities could be affected either by the actual or expected economic effects of a continuation in climate change (physical risks), or by an adjustment towards a low-carbon economy (transition risks),” the report states.

For now, the report indicates, physical risks on asset prices appear “relatively contained” but may be “subject to considerable tail risk,” a form of portfolio risk related to movements in an investment. The report states that the manifestation of physical risks, prompted for example by “a self-reinforcing acceleration in climate change and its economic effects” could lead to sharp decreases in prices and increases in uncertainty. “Some emerging market and developing economies (EMDEs) that are more vulnerable to climate-related risks, especially those in which mechanisms for sharing financial risk are less developed, may be particularly affected,” the report states.

But, the report notes, a disorderly change to a low-carbon economy could also be problematic. “In such a scenario, physical and transition risks might combine, amplifying their overall effect on financial stability,” the report states.

A well-anticipated transition to a low carbon economy, on the other hand, would present risks that are relatively contained, the report states, “although there are many measurement uncertainties.”

The report states there are various actions that financial institutions can take or are taking to reduce or manage their exposure to climate-related risks. “However, some authorities find that these are not applied systematically by most firms,” the report states. “The efficacy of such actions taken by financial firms may also be hampered by a lack of data with which to assess clients’ exposures to climate- related risks, or the magnitude of the effects described above. Actions taken by individual financial institutions may also not by themselves mitigate broader climate-related risks to financial stability. Robust risk management might be supported by initiatives to enhance information with which to assess climate-related risk.”

The Implications of Climate Change for Financial Stability

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