Preparing for How Climate Change Could Alter the Financial System

The impacts of climate change extend beyond physical and environmental harm. Even the financial sector is at risk.

• By Jane Marsh
• Jan 11, 2024

The impacts of climate change extend beyond physical and environmental harm. Even the financial sector is at risk. How much actual damage occurs depends on how well financial experts and policymakers prepare.

Primary Effects of Climate Change on the Financial System

Rising temperatures, forced displacement, extreme weather events and other far-reaching impacts of climate change can critically destabilize the financial industry. For one, the costs of the physical damage from these events alone are substantial. In 2022, severe weather conditions caused over $165 billion in damage, according to the National Oceanic and Atmospheric Administration.

There are also expenses resulting from the damage to land and infrastructure. Intense flooding on farmlands can abruptly halt food production, causing supply to drop and prices to soar. This impact cuts across domestic and international markets. The International Monetary Fund estimates a 1 percent drop in global harvests leads to an 8.5 percent increase in food prices. 

Households bear the brunt of the spending associated with physical damage from climate change. For example, rising frequencies of extreme weather events will result in higher home insurance premiums annually. Higher food costs mean lower disposable income, making saving or investing more difficult. Plus, it increases the risk of people defaulting on their loans, impacting the credit system as a result.

Transition Risk and the Financial Sector

Climate change can also disrupt the financial industry through transition risk. This is the risk from changes in market sentiment, innovations and government policies as the world adopts more sustainable practices.

Transition risk almost certainly leads to significant economic changes. The government provides tax incentives for businesses and individuals who opt for eco-friendly products and services. Additionally, consumer preferences are shifting — more are prioritizing green solutions, even if it means paying extra. Companies will have to adapt or risk failing, further impacting demand for liquidity in the economy.

The effects of transition risk extend to the global scene. Changes in a country's domestic policies impact bilateral trade agreements with wide-ranging implications. For instance, oil exports play a fundamental role in America’s economy, with over 9.5 million barrels transported daily in 2022.

Oil exploration is a known causal agent of climate change, leading many countries to adopt policies aimed at engineering a shift toward more eco-friendly alternatives. This potential drop in demand will no doubt impact global oil prices with reverberations across different economic sectors.

What Is Being Done About These Effects?

Policymakers and stakeholders have proposed several ways to combat the financial stability implications of climate change on a global level. The first is through regulation changes that will require financial institutions to disclose their climate change risks publicly and demonstrate their ability to manage them. President Biden signed an executive order on climate-related financial risks to this effect in 2021. In the United Kingdom, insurance firms have begun stress-testing climate change scenarios to ensure their policies can provide adequate coverage for physical and transition risks.

Another option in the works is green quantitative easing measures, which would involve Central Banks giving more favorable bond-buying and liquidity terms to environmentally responsible beneficiaries. The Japanese government recently announced its new climate strategy, which aims to provide zero-interest loans to sustainable projects and related practices. These measures could encourage increased investment in green projects and technologies in the future.

Updating monetary policies to factor in climate change's financial risks is also a promising effort. For example, in the UK, there are growing calls for the Bank of England to impose a brown-penalizing factor on financial institutions that lend money to carbon-intensive industries. This means banks that want to finance fossil fuel projects must put higher capital requirements on loans. On a broader scale, plans to engineer a shift away from fossil fuels were formally adopted by 200 countries at the recently concluded COP28 summit.

How to Prepare for Climate-Related Financial Risks

At the individual level, it is important to consider the implications of climate change when making spending and investing decisions. For example, review the portfolio to identify financial components exposed to climate-fueled risks.

Prioritizing the spending on environment-friendly products and services is also a great way to move the needle on market sentiment toward sustainable policies. For a small business owner, green monetary regulations provide new opportunities to obtain financing, provided they align their corporate values with eco-friendly practices.

Climate Change Will Alter the Financial System 

The effects of climate change include broad financial consequences across all levels. It falls squarely on financial institutions and policymakers to plan for this emerging systemic risk. Now is the time to act. Delay will only increase the chances of a full-blown destabilizing shock across the financial system and, by extension, the broader economy.