A team of economists recently analyzed two decades of peer-reviewed research on the social cost of carbon, an estimate of the damage from climate change. They concluded that the average cost of applying the improved method was significantly higher than the most recent figures from the U.S. government.
This means that over time, greenhouse gas emissions will cause more harm than regulators calculate. As tools to measure the link between weather patterns and economic performance evolve, and as the interaction between weather and the economy magnifies costs in unpredictable ways, damage estimates have only increased.
This is the kind of data you might expect to set off alarm bells across the financial industry, which closely tracks economic developments that could affect stock and loan portfolios. But even the ripples were difficult to detect.
In fact, most of the recent Wall Street news has been about withdrawals from climate goals rather than recommitments. Banks and asset managers have withdrawn from international climate alliances and are unhappy with their rules. Local banks are stepping up lending to fossil fuel producers. Sustainable investment funds have continued to see significant outflows and many have collapsed.
So what explains this apparent disconnect? In some cases, this is a classic prisoner's dilemma. When companies collectively transition to clean energy, a cooler climate will be more beneficial to everyone in the future. But in the short term, the transition becomes much more difficult to achieve because each company will have individual incentives to make money from fossil fuels.
And when it comes to preventing climate damage to its own operations, the financial industry is truly struggling to understand what a warming future means.
To understand what's going on, put yourself in the shoes of a banker or wealth manager.
In 2021, President Biden rejoined the United States in the Paris Agreement, and his financial regulators began issuing reports on the risks climate change poses to the financial system. A global pact of financial institutions has made $130 trillion worth of commitments to reduce emissions, with assurances that governments will build the regulatory and financial infrastructure to make these investments profitable. And in 2022, the Inflation Reduction Act was passed.
Since then, hundreds of billions of dollars have flowed into renewable energy projects in the United States. But that doesn't mean it's a sure bet for those who get paid to build their investment strategies. Clean energy stocks have been hit by high interest rates and supply chain issues, which have resulted in the cancellation of offshore wind projects. If you had bought some of the largest solar energy exchange-traded funds in early 2023, you would have lost about 20% of your money while the rest of the stock market soared.
“It’s really hard to think about what’s the best way to tilt your portfolio in a way that will produce profits,” said Derek Schug, director of portfolio management at Kestra Investment Management. “This is probably going to be a great investment over 20 years, but judging over one to three years is going to make it a little bit more difficult for us.”
Some companies serve institutional clients, such as public employee pension funds, who have made addressing climate change part of their investment strategy and are willing to take a short-term hit. But they are not the majority. And over the past few years, many banks and asset managers have backed away from anything with a climate label for fear of losing business from states that frown on such concerns.
Moreover, the war in Ukraine has disrupted the financial picture to support a rapid energy transition. Artificial intelligence and the move toward electrification are increasing electricity demand, but renewable energy is not keeping up. So banks have continued to lend to oil and gas producers that are making record profits. JPMorgan Chase CEO Jamie Dimon said in his annual letter to shareholders that it would be “naive” to simply halt oil and gas projects.
It's all about the relative attractiveness of investments that slow climate change. What about the risks climate change poses to the financial industry's own investments through more powerful hurricanes, grid-destroying heat waves, and wildfires wiping out cities?
There is evidence that although banks and investors do take some physical risks into account, much of it is still ignored.
Over the past year, the Federal Reserve has asked the nation's six largest banks to examine what would happen to their balance sheets if a major hurricane hits the Northeast. In a summary last month, the agencies said a lack of information about property characteristics, counterparties and especially insurance coverage made it difficult to assess the impact on loan delinquency rates.
Parinitha Sastry, an assistant professor of finance at Columbia Business School, studied unstable insurers in states like Florida and found that coverage was often much weaker than expected, making mortgage defaults more likely after hurricanes.
“I am very concerned because the insurance market is such an opaque and weak link,” Dr. Sastry said. “There are parallels and complex connections to what happened in 2008, when weak and unregulated markets affected the banking system.”
Regulators worry that failure to understand these ramifications could not only leave a single bank in trouble, but could also become an epidemic that weakens the financial system. They established a system to monitor potential problems that some financial reformers criticized as inadequate.
But while the European Central Bank (ECB) considers climate risks in its policies and oversight, the Federal Reserve (Fed) has been more proactive despite signs that extreme weather events are fueling inflation and high interest rates are slowing the transition to clean energy. refused to play a role.
“The argument was, ‘If we can’t convincingly show that this is part of our mission, then Congress has to deal with it and that’s not our job,’” said Johannes Stroebel, a finance professor at New York University’s Stern School of Business. He said.
Ultimately, that view may prove correct. Banks are in the business of risk management, and as climate prediction and modeling tools improve, they may stop lending to companies and places that are clearly at risk. But that only creates more problems for people in the area as credit and business investment dries up.
“You could conclude that there is no threat to financial stability, but there could still be significant economic damage,” Dr. Stroebel said.
While it's still difficult to assess where the risk in a portfolio lies, uncertainty looms in the much more immediate future. The outcome of the U.S. election could determine whether further action is taken to address climate issues or whether existing efforts are rolled back. An aggressive climate strategy may not succeed in a second Trump administration, so it might seem wise to wait and see how it shakes out.
“Given the way our system has moved so far, it is so slow that there is still time to get to the other side of the proverbial wall,” said Nicholas Codola, senior portfolio manager at Brinker Capital Investments.
John Morton served as a climate counselor to Treasury Secretary Janet L. Yellen before rejoining Pollination Group, a climate-focused advisory and investment management firm. He observed that large corporations are hesitant to make climate-sensitive investments as November approaches, but said “two things are wrong with that hypothesis and it is quite dangerous.”
One: States like California are enacting stricter rules on carbon-related financial disclosures and could tighten them further if Republicans win. And two: Europe is phasing in a ‘carbon border adjustment mechanism’ that will punish polluting companies trying to do business there.
“Our view is that we have to be careful,” Mr. Morton said. “If you are left with a big bag of carbon 10 years from now, you will be penalized in the market.”
But now even European financial institutions are under pressure from the United States, which has offered some of the most generous subsidies to date for renewable energy investments but has not put a price on carbon.
Global insurance company Allianz has set out a plan to adjust its investments in a way that would prevent a temperature rise of more than 1.5 degrees Celsius by the end of the century if everyone did so. But it's difficult to steer portfolios towards climate-friendly assets while other funds are buying up polluting companies and making short-term profits for impatient clients.
“Really engaging clients is a key challenge for asset managers,” said Markus Zimmer, economist at Allianz. Asset managers don't themselves have enough tools to move money from dirty investments to clean investments if they want to stay in business, he said.
“Of course it helps if the financial industry is somewhat ambitious, but it can’t really replace the lack of action from policymakers,” Dr. Zimmer added. “At the end of the day, it’s just too hard to get around.”
The faster we decarbonize, the greater the benefits, as the risk of extreme damage increases over time, according to new research. But without uniform rules, some will reap the immediate benefits while others will be at a disadvantage, and the long-term consequences will be unfavorable for everyone.
“The worst thing that can happen is that you stick to your business model at 1.5 degrees and realize 3 degrees,” Dr. Zimmer said.