Most Surprising Thing about a New Report Showing Climate Change Imperils the U.S. Financial System Is That the Report Even Exists

Our key finding – and the one that underlies every recommendation – is this: Climate change, partly by increasing the risks and severity of wildfires, hurricanes and other disasters, poses a threat that permeates the U.S. financial system. And so the government needs to make climate-related risk more visible and prepare the financial system for disruptions.

Managing Climate Risks
Two types of risks are associated with climate change: physical and transition.

Physical risk has dominated the news lately in coverage of wildfires and storms. It’s simply the threat climate change poses to life, property and public health.

Just as smoke from the fires in the West has blown across much of the United States, the impacts of those fires, and other disasters, can drift through the U.S. financial system with cascading consequences.

Transition risk, on the other hand, is more about the costs associated with our responses to climate change, such as sudden shifts in policy or in people’s preferences and behaviors.

If governments took sudden, dramatic action to reduce the use of fossil fuels, through a high price on carbon or a stronger mandate, the values of the companies that find, extract, process and deliver those fuels could plummet. The companies susceptible to rapid devaluations as a consequence of government actions – or shifts in societal preferences – thus have high transition risk, which should accordingly reduce their value today.

Helping the System See the Risks
However, for investors to take physical and transition risks into account, these risks have to be quantified and disclosed.

A first step, and the report’s most important recommendation, is that legislators should put a price on carbon emissions. The government currently subsidizes the cost of fossil fuels through tax breaks and other mechanisms. Incorporating the full cost of climate disruption into the price of these fuels would help redirect huge sums of money into climate-friendly technologies and industries.

But alone it’s not enough, since the climate is already being disrupted, and more needs to be done to help the financial system see and react to a variety of changing risks.

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The government can help banks and other financial companies do this by specifying how they should measure and report their financial risks from climate change. The government can also require publicly traded companies across all sectors to identify and report climate risk using transparent measurement techniques, so that investors trust the numbers, which need to be comparable across institutions and, ideally, sectors, so people can use them in decision-making.

The economic risks of climate change in the U.S. financial system are currently too hard for investors and regulators to see.

Illuminating them will help markets work to everyone’s benefit. First, this will lower the risk of a sudden market crash. Second, clear, comparable risk information will discourage investment in climate-disrupting activities and motivate economic actors to incentivize further solutions.

Jeffrey Dukes is Director of the Purdue Climate Change Research Center, Purdue University. This article is published courtesy of The Conversation.