A team of economists analyzed 20 years of research on the social cost of CO2, an estimate of the damage caused by climate change. Bottom line: The average cost – revised with better methods – is much higher than the most recent figure from the US government.
In other words, greenhouse gas emissions, over time, will cost more than the authorities anticipate. These estimates keep rising: the tools to measure the link between weather events and economic output are improving. Furthermore, the climate-economy interaction amplifies costs in unpredictable ways.
You’d think this kind of data would ring alarm bells in the financial industry, which scrutinizes economic data that could impact stock and loan portfolios. But no.
On the contrary, Wall Street recently seems to be losing interest in climate goals. Bankers and asset managers are leaving international climate alliances and becoming irritated by their rules. Banks are increasing their loans to hydrocarbon producers. Sustainable investment funds suffered big losses and several closed.
How can this discrepancy be explained? Often, these are classic cases of the Prisoner’s Dilemma: If companies collectively adopt cleaner energy, a cooler climate will benefit everyone in the future. But in the short term, each company sees that oil, gas and coal are profitable, which hampers the transition.
However, the financial sector is struggling to understand the financial impact of global warming on its activities.
Put yourself in the shoes of a banker or asset manager.
In 2021, President Joe Biden reentered the United States into the Paris Agreement. The country’s financial authorities have started publishing reports on climate risk to the financial system. An international group of financial institutions has made $130 trillion in commitments to reduce emissions, counting on governments to create regulatory and financial infrastructure to support these investments. In 2022, the US Inflation Reduction Act was passed.
High interest rates and supply issues have weighed on clean energy stocks, leading to the cancellation of offshore wind projects.
Shares of large exchange-traded funds devoted to solar energy have fallen 20% since January 2023, while the rest of the stock market has soared.
Green investing is “very difficult” in the context “of trying to tilt your portfolios towards profits,” observes Derek Schug, portfolio manager at Kestra Investment Management.
Some institutional clients, such as public pension funds, are patient with returns and are willing to include the fight against climate change in their investment strategy. But they are in the minority. For two years, many banks and asset managers have given up on any green investment, for fear of losing clients in states that reject this type of concern.
Additionally, the war in Ukraine has muddied the financial arguments for a rapid energy transition. Artificial intelligence and electrification are increasing energy demand. As wind and solar power are not keeping up, banks have continued to lend to the oil and gas sector, which is making record profits. According to JPMorgan Chase CEO Jamie Dimon, simply shutting down oil and gas projects would be “naive.”
All of the above concerns the relative attractiveness of investments that would slow climate change. What about the risk that climate change poses to financial sector investments, more powerful megahurricanes, heat waves that knock out the power grid, wildfires that devour cities?
Bankers and investors appear to be taking into account some physical risks, but much of this risk has yet to be revealed.
For a year, the Federal Reserve has asked the six largest American banks to calculate the impact that a major hurricane in the northeast of the country would have on their balance sheets. A summary published in May reveals that these banks struggle to assess the impact on the loan default rate: they lack information on the characteristics of the properties, their counterparties in the risk and especially the insurance coverage.
Pari Sastry, a finance professor at Columbia Business School, has studied weak insurers, particularly in Florida. She says coverage is often weak there, making mortgage defaults more likely after hurricanes.
Regulators, too, are concerned: misunderstanding these knock-on effects could endanger not just a bank, but the entire financial system. They have set up systems to monitor potential problems, which some reformers denounce as inadequate.
The European Central Bank has taken climate risk into account in its policy and oversight, but the Federal Reserve has refrained from taking a more active role. This even though it is clear that extreme weather conditions are fueling inflation and high interest rates are slowing the transition to clean energy.
“The Fed’s argument is: ‘Unless we can clearly demonstrate that this is part of our mandate, it’s up to Congress to deal with it, it’s none of our business,’” says Professor Johannes Stroebel. in finance at New York University’s Stern School of Business.
Defining portfolio risk is always difficult, but there is shorter-term uncertainty: the outcome of the U.S. presidential election could determine whether further climate action will be taken or the current effort reversed. Investing heavily in the green economy could go wrong if Donald Trump is elected, so it seems wise to wait.
“Given how slow our system has been so far, there might still be time to jump to the other side of the fence,” observes Nicholas Codola, portfolio manager at Brinker Capital Investments.
John Morton served as climate advisor to Janet Yellen at the Treasury Department before joining the Pollination Group, a climate-focused advisory and portfolio management firm. He notes that big companies are hesitant to invest in green projects as the election approaches; according to him, this hesitation contains “two erroneous and very dangerous things.”
First: California and other states are adopting stricter rules for financial reporting on CO2 emissions and could strengthen them if Donald Trump wins. Second: Europe is setting up a “carbon border adjustment mechanism”, which will punish polluting companies wishing to sell their products on its territory.
“Our advice: be careful,” Mr Morton says. “You will be at a market disadvantage if you end up with a big bag of carbon in 10 years. »
