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Failure to address climate change could lead to global economic collapse

Author: ICAEW Insights

Published: 06 Jul 2021

A new report maps out the uneven impacts of climate change for the EU financial sector and warns that failure to act could lead to a decline in global GDP of up to 20% by 2100.

A joint report Climate-related risk and financial stability published last week by the European Central Bank (ECB) and the European Systemic Risk Board (ESRB) provides a granular assessment of the potential impacts of climate change on millions of global firms and thousands of financial firms in the EU. It underlines the crucial need for quick action to ensure an orderly transition to a low-carbon economy, limiting long-term disruption to economies, businesses and livelihoods. 

The report maps out prospective financial stability risks and establishes a detailed topology of physical and transition risks arising from climate change across regions, sectors and firms. In addition, it also applies a scenario analysis with long-dated financial risk horizons with a view to identifying potential financial losses resulting from timeliness and effectiveness of mitigation and adaptation strategies.

Varying risk concentrations

Three forms of risk concentration are identified in the report. First, physical climate risks are concentrated at the regional level. In Europe, river floods are likely to be the most widespread climate risk driver in the next twenty years – alongside vulnerabilities to wildfires, heat and water stress. Around 30% of the eurozone’s banking sector’s credit exposures to non-financial companies are to entities that could be subject to a combination of physical hazards.

Second, exposures to highly emitting firms are concentrated both across and within economic sectors – and amount to 14% of collective eurozone banks’ balance sheets. Emission-intensive firms are particularly evident in the manufacturing, electricity, transport and construction sectors; the intensity of emissions can vary widely within each sector.

Third, climate risk exposures are concentrated in specific European financial intermediaries. The report finds that 70% of banks’ credit exposures to companies with high or increasing physical risks in the coming decades are held by only 25 banks. Large investment funds may also be impacted by financial market repricing driven by transition risks, given more than 55% of their investments are biased towards high emitting firms. 

Modelling the impact of disorderly transition

Three long-term scenarios are analysed in the report – a reference orderly scenario, a destabilising disorderly scenario and a ‘hot house world’. In the event of a disorderly climate transition, physical risk losses would become dominant in around 15 years, particularly for high-emitting firms. The ECB and ESRB estimate that insufficient or ineffective mitigation could lead to economic collapse by the end of the century, with an estimated drop in global GDP of up to 20%. On the other hand, timely and orderly macroeconomic policies to address climate-related risks could significantly reduce financial stability risks. 

While the ECB and ESRB will continue work on better measurement and modelling of climate risks, the report will provide additional evidence of the need for action, including ahead of the European Commission’s forthcoming sustainable finance strategy, due next week, and its ‘fit for 55’ package, expected mid-month. 

Here is a link to the ECB/ESRB Climate-related risk and financial stability report 

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