The physical risks of climate change, including both gradual global warming and an increase in extreme weather events, are likely to cause increasing financial and economic losses. Lower and middle-income countries may be more vulnerable to physical risks due to their reliance on climate-sensitive economic sectors and their limited capacity to absorb economic losses. However, vulnerable regions in developed countries are also at risk and impacts will also be felt through the global nature of many supply chains.
Economic risks and impacts due to the physical risks of climate change include demand and supply-side losses, reductions in economic growth, destruction of public and private capital, and output losses. Impacts will be experienced at the macro-economic level as well as by individual actors such as companies and investors. Consequently, policy-makers, investors, and companies will all play a role in responding to the growing financial threat from climate change (MacWilliams et al., 2019).
Despite the potential economic losses and the likelihood that all investments and asset classes are exposed to the physical risks of climate change to some degree, few actors in the financial sector are incorporating physical risks into decision-making. The Task Force on Climate-Related Financial Disclosures (TCFD), launched in 2015, has developed a series of recommendations for companies to disclose their climate-related risks. Investors can then use this information to make informed capital allocation decisions. The TCFD argues that increased transparency around climate change risks will lead to more efficient markets and more stable and resilient economies. However, it is also possible that a better understanding of physical risks could lead to capital flight from risk-exposed investments and a lack of access to finance for those who need it most.
Findings
- There are challenges in assessing physical risks. It is possible to assess the immediate costs of changing weather patterns and more frequent and intense natural disasters, but translating this into expected future risks is difficult (Grippa et al., 2019; Miller & Swann, 2019). There is also an assumption amongst actors that climate risk is owned by governments, which may make it difficult to integrate physical risks into financial decision-making.
- This rapid review did not locate any examples of capital flight from developing countries due to a better understanding of the physical risks of climate change.
- The physical risks of climate change will differentially affect businesses and the financial performance of sectors, and as well as creating risks, could also create opportunities for investors (UNEP FI, 2018).
- Potential mechanisms for building resilience to natural disasters and facilitating recovery following a disaster could help vulnerable countries and regions adapt to the physical risks of climate change. Mechanisms discussed in the literature include:
- Investing in resilient infrastructure: Marto et al. (2017) find that investments in adaptation infrastructure lead to reductions in the magnitude of economic damage following a natural disaster, as well as reduced risk of debt distress.
- Sovereign risk insurance: Bevan and Adam (2016) find that insurance may or may not be helpful depending on detailed circumstances, with the value of insurance being highest when the worst-case disaster materialises. The benefits of insurance must also be weighed against the carrying costs and the conditions of the contract.
- Bond financing: Mittnik et al. (2019) find that bond financing can accelerate recovery and it can lead to output, consumption and private and public capital rising again following a disaster. It can also help to reduce the frequency and severity of natural disasters through financing adaptation. However, there may be limitations to bond issuing and credit expansion in low-income countries, particularly small countries.
Evidence base
The evidence base for this request was extremely limited. Only one report produced for the United Nations Environment Programme’s Finance Initiative directly addressed the risk of capital flight. This review found small but growing bodies of literature on the macro-economic risks of climate change; the economic consequences of extreme weather events; policy options for improving resilience to and recovery following an extreme weather event; and, climate change as an opportunity for investors. This report undertook a series of keyword searches and review of
relevant websites including the IMF, the World Bank, the Bank of England, and credit rating agencies amongst others.
