The summit came days after G7 finance ministers backed a push for mandatory climate disclosures, the Bank of England told banks to begin quantifying climate risks, and the Biden administration charged federal agencies with assessing and addressing the potential economic toll of climate change.
There has no doubt been a shift since former Bank of England governor Mark Carney suggested in a now-famous 2015 speech, “Breaking the tragedy of the horizon,” that climate change would threaten global financial stability, resilience, and prosperity. Yet while global efforts have accelerated, we remain at a crossroads. Financial institutions and the supervisors that regulate them have significantly increased their efforts to measure climate risks. At the same time, most of these assessments still seem ‘apart’ from mainstream risk management and decision-making. Beyond the topic of climate change, there is little progress on issues such as ecosystem loss and risks to social cohesion and resilience, both of which are dramatically influenced by climate change and the transition to net-zero. The complexity and uncertainty of these risks represents a challenge to actioning our insights. And for most financial institutions, incentives are still geared towards short-term risk-return optimization. In short, as we embark on perhaps the most decisive decade in tackling climate change and its connected risks, we still lack the insights, capacity, and – perhaps most crucial of all – institutional resilience to weather these risks and contribute to their mitigation.
The devastation wrought by COVID-19 now presents us with an unprecedented opportunity to put these risks at the heart of the financial and policy agenda.
The financial system has a critical role to play in addressing these issues, since it is not only exposed to these risks, but also drives and can help reduce them. However, it does not currently play this part, due to three challenges that act as barriers to more concerted action.
First, while time horizons on the asset and liability side in the investment process may be long-term, the investment process itself artificially shortens these horizons, rendering them “blind” to many future challenges. Second, even when financial institutions “open their eyes,” the complexity and uncertainty of these risks renders them difficult to capture in risk models and traditional management approaches. Lastly, even with clear perception and understanding of how to tackle these issues, there is still limited incentive to act.
While these are significant challenges, in our view, there are three strategies for removing such barriers to action. First, it is critical to develop long-term risk metrics to help fix the short-term focus of financial markets. This will involve determining performance metrics and criteria to define long-term investment and lending processes. In turn, this will help financial institutions and supervisors better understand future risks and how taking the long-term view can drive both financial and sustainability performance. Second, it will be necessary to develop new types of risk management tools, models and frameworks – centered on the concept of preventing, preparing, and “building back better” when these risks materialize. This includes stress-testing tools, monitoring systems, and auditing systems to assess financial institutions’ approaches to risk management. Third, and perhaps most importantly of all, there must be a sea change in the public and private sectors, incentivizing financial institutions to mitigate and adapt to future challenges.
By working on these three key issues, the financial sector will shift from being a frequent victim or driver of risks, to being a provider of solutions.
More than five years after Carney’s speech, we are of course heartened by developments such as the Green Swan conference, which shows financial and policy decisionmakers may finally be putting their money where their mouths are. But the pace of change is still too slow, and usual ways of doing business are too entrenched. After all, most governments have failed to use the ‘opportunity’ of COVID-19 to pass environmentally sustainable recovery packages. Leading European economies are set to waste a whopping two-thirds of pandemic recovery funding plans on unsustainable, environmentally damaging sectors (Finance Watch 2020) – leaving Europe vulnerable to climate change and falling living standards.
Not acting is a moral failing, as it will only deepen our dependence on current unsustainable systems and will set the stage for challenges and risks of the future – global temperatures rises, extreme weather events, systemic loss of ecosystem services, breakdown of social order, increased risk of other pandemics, and all the problems that come with it. We have the chance now to take more concerted action. Mitigating and adapting to 2030 risks requires action today.
By Jakob Thomae, Managing Director (2° Investing Initiative Germany) and Head of the 1in1000 Program, & Anne Schoenauer, Deputy Research Head, 1in1000 Program.
1in1000 is a new research program by 2° Investing Initiative that brings together new & existing research projects on long-termism, climate change, and associated future risks for financial markets, the economy, and society. For more information on the program, visit: https://www.1in1000.com/.