Climate Change: Physical Risk and Equity

After completing this reading, you should be able to:

• From the perspective of physical risk, describe the channels through which climate change can affect financial stability.
• Explain how climate change and climate risk have affected equity prices and equity valuations.
• Discuss how country characteristics such as insurance penetration and economic development impact the extent to which climatic disasters affect equity prices.

The Impact of Climate Change on Financial Stability

Compared to pre-industrial levels, global temperatures have increased by 1.1 degrees Celsius, and climate scientists have attributed this change to human-made (anthropogenic) greenhouse gas emissions. In the next few decades, global temperatures’ trajectory will largely depend on mitigation measures to reduce pollution. Based on the current mitigation policies, it is expected that by the end of the century, future anthropogenic greenhouse gas emissions will lead to warming of around 3 degrees Celsius. In turn, climate change caused by this rise in temperature is projected to adversely affect the world’s stock of natural resources, contribute to a substantial rise in sea level and increase the frequency and severity of severe weather incidents.

Physical Risk

Physical climate-related risks represent the financial and economic losses due to the increasing frequency and intensity of climate-related events such as floods, heatwaves, or hurricanes and the consequences of long-term changes in climate trends such as rising sea levels, acidification of the oceans, and changes in precipitation due to rapidly increasing emissions of greenhouse gases.

Physical risks may impact both the supply and demand sides of the economy, such that:

1. On the supply side, natural disasters interrupt business trade and operations and damage infrastructure, thus diverting capital to replacement and restoration from innovation and technology; hence impacting labor productivity, raising the cost of replacement and repair, and speeding up capital stock depreciation. This impacts the production levels and growth.
2. On the demand side, natural disasters will increase repair and replacement expenditures, reduce investment possibilities, and increase consumer demand for other goods. The dampening of business investment could also occur due to uncertainty about future demand and growth prospects and substantial price impacts. Frequent extreme weather events facing households may increase precautionary saving, which may depress private consumption in the long-run.

From the physical risk viewpoint, climate change will influence financial stability across two main channels:

I. Loss of Physical and Human Capital

A climatic hazard that affects a large area has negative impacts on both households and financial institutions. Households may lose their homes and other personal property. Insurers are faced with unprecedented claim amounts that may deplete their reserves and push them to the edge of bankruptcy.

Banks may see an increase in defaults in their loan portfolios as borrowers struggle to meet scheduled payments. Banks may also be exposed to operational risks, such as the destruction of physical structures and communication systems. In addition, they may be exposed to liquidity risk as depositors rush to withdraw their savings in masses.

A stable insurance sector helps to minimize the effect of a major climatic event by indemnifying policyholders. This can reduce the impact on other economic agents. The government can also help by providing financial aid and other forms of support in the aftermath of the disaster.

II. Recognition of Physical Risk during Valuation of Assets

Climatic hazards may form beliefs among investors that similar events will most likely reoccur some time in the future. As such, investors will demand a premium for holding any asset exposed to a future increase in physical risk. This implies that an asset exposed to a future increase in physical risk will have a lower price compared to similar asset that’s not exposed to a change in physical risk. This type of physical risk  is long-term and is subject to socioeconomic developments and climate variables that are difficult to model. As a result, markets often fail to accurately price physical risk, leading to economic inefficiency and capital misallocation. From a financial stability perspective, the value of assets tends to drop with a sudden shift in investors’ perception of future physical risk, significantly impacting the balance sheets of financial institutions and investor portfolios.

Implications of Climate Change

Equity Pricing and Valuation

Stock markets play a central position in financial systems and provide a favorable setting to analyze the effect of the physical risk attributable to climate change. Over the past 50 years, looking back at about 350 major climate disasters (in a sample of 68 economies which make up 95% of the global GDP), financial researchers have found that the average impact has been modest: a decrease of 2% for banking stocks and 1% for the entire economy.

The aggregate market effect has been greater than 14% in 10% of the cases, suggesting that some climate events can significantly impact financial stability. For instance, Hurricane Katrina had no discernible effect on the U.S. stock market index in 2005. This is despite the fact that the disaster caused the greatest harm in absolute terms – approximately 1 percent of U.S. GDP. In comparison, the 2011 floods in Thailand resulted in the largest damage relative to the size of the economy – at 10.1% of the Thai GDP. In addition, the stock market plunged by more than 8% in the immediate aftermath of the event. After 40 days of trading, the cumulative drop had risen to 30%.  

Current Equity Valuation

Equity investors find it difficult to put a price on an increase in physical risk attributed to climate change. This happens because of the following reasons:

• Investors are faced with a situation where they have to estimate the probability of different climate scenarios and how each scenario will affect the level of physical risk at the firm-level. This is complicated by the fact that the level of response and disaster preparedness differs from firm to firm. While at it, they also have to take into account the physical location of each firm’s production facilities and suppliers. They also have to consider the fact that a firm’s production site can change in the future.
• The time horizon over which a change in physical risk is likely to unfold could be longer than what long-term institutional investors are used to.

Research shows that following large disasters, insurers in industrialized economies have had a significant reaction to their stock prices. In contrast, stock prices of insurers in emerging markets and developing economies tend not to show any significant reaction. What could be behind the different outcomes? Three reasons have been put forward as follows:

• In developing economies and emerging markets, a substantial share of insurance is offered by subsidiaries of insurers listed abroad. Thus, local insurers do not bear the brunt of the disasters.
• In emerging and developing economies, insurers listed domestically do not or hardly cover climate disasters.
• In emerging and developing economies, insurers reinsure a substantial share of their climate disaster exposure. This way, they are able to absorb losses associated with disasters without suffering significant financial strain, and the stock price remains stable in the aftermath. The stocks of reinsurers, however, tend to plunge following a disaster in both advanced and emerging economies.

For banks, there is a small negative stock market response in both advanced and emerging economies.

Role of Insurance Penetration and Sovereign Financial Strength in Cushioning the Equity Market Effects of Climatic Disasters

Insurance penetration and sovereign financial strength are two key economy-wide features that can increase resilience in the face of a climatic disaster. So, how do the two increase resilience?

• According to econometric analysis, a higher rate of insurance penetration dampens the effect of large disasters on equity return. However, there is a significant variation of insurance penetration across economies. The stock market in economies with a higher level of insurance penetration generally enjoy more protection.
• A sovereign’s financial strength matters since it directly impacts the government’s ability to respond to disasters by (I) offering explicit insurance programs, (II) offering financial relief, and (III) launching reconstruction programs. It essentially absorbs the impacts of large disasters on equity return. It has a positive impact on equity return. For instance, a one percent improvement in sovereign rating increases the aggregate market return by 0.2 percent and consecutively average of 0.3 percent on industrial and banking sectors.

However, when looking at disasters with the largest negative impacts on the equity returns, the effects are statistically stronger and quantitatively larger. For instance, when sovereign ratings are low, the aggregate market returns are between 0.6 to one percent. It implies a significant relationship between the two characteristics and higher returns in the immediate aftermath of a disaster, commonly referred to as abnormal returns 40 trading days post the onset of a disaster for the aggregate stock market. Therefore, sovereign financial strength and insurance coverage are crucial factors in maintaining financial stability regardless of future climatic shocks’ size.

Practice Question 1

Which of the following best describes how a country’s characteristics impact the extent to which climate disasters affect equity returns?

A. A higher rate of insurance penetration dampens large disasters’ effects on equity return

B. The strong financial ability of a country absorbs the impacts of large disasters on equity return

C. Risk-sharing mechanisms offered by financial markets mitigate damages suffered due to disaster-related events, thus limiting the expected impact on equity prices

D. All of the above

Solution

The correct answer is D.

The insurance penetration and sovereign strength of a country can increase resilience against climatic disasters through:

• The strong financial ability of a country absorbs the impacts of large disasters on equity returns.
• Risk-sharing mechanisms offered by financial markets mitigate damages suffered due to disaster-related events, thus limiting the expected impact on equity prices.
• A higher rate of insurance penetration dampens large disasters’ effects on equity return.

Practice Question 2

Which of the following economic sectors plays the most significant role in mitigating the effect of climatic hazards on the economy?

   A. Banks

   B. Insurance

   C. Hedge funds

   D. Oil and gas

Solution

The correct answer is B.

The provision of insurance concentrates the impact of the shock on the insurance sector and reduces the impact on other economic agents. A stable insurance sector means that all policy holders will be indemnified (compensated) and their financial situation restored to pre-disaster status.