Climate Risks To The Financial System

Howard Covington

Cambridge University, Isaac Newton Institute for Mathematical Sciences

October 27, 2015

Abstract:

An estimate is made of the specific risk to the fossil fuel sector from wind and solar generation and from electric vehicles. The systemic risk to investment portfolios from climate change is then analyzed.

Climate Risks To The Financial System – Introduction

In a speech to insurers and investment experts at Lloyd’s of London in October 2015, Mark Carney, the Governor of the Bank of England, expressed concern about the risks to financial stability from climate change. He observed that an agreement by governments to limit warming to 2° (centigrade, compared to pre-industrial) will create a specific risk for the fossil fuel sector through the changes in asset values it will trigger. In the absence of an agreement, the systemic risk to the world economy from future climate damage will continue to rise. Either outcome may create financial instability.

Specific Risk

Even without further actions by governments, fossil fuels will experience increasing competition from renewables. In the last decade wind and solar grew by 20% and 40% a year respectively and now jointly account for just under 5% of electricity generation3. They are at or approaching cost parity in many markets and their costs are expected to go on falling. The advent of cost-effective domestic batteries and the development of smart metering in the next decade will further boost demand for domestic solar. Industry projections of long-term average growth in annual installations of generating capacity are in the range 0% to 4% for wind and 5% to 10% for solar. These translate into 10% to 15% pa near-term growth in renewables generating capacity. It takes seven years to double capacity at 10% pa growth and 5 years at 15% pa. Three capacity doublings would lift the renewables market share of generation towards 40%.

Cost-effective batteries will bring the capital cost of electric vehicles below those of petrol vehicles in the early 2020s with life-time ownership costs expected to be significantly less. Sales of electric vehicles may increase by around 40% a year in the next five years, taking their share of light vehicle sales from less than 0.5% now to around 3%. Growth in autonomous vehicles in the 2020s and their use with taxi hailing apps have the potential to transform urban light vehicle use and to boost the share of electric vehicles in global light vehicle sales.

A sense of the consequences of these technology changes can be obtained by starting from industry projections for coal and gas use in electricity generation and for oil use in transport and adjusting them for reasonably fast growth in renewables and electric vehicles. This produces a picture of coal and gas demand for electricity generation that peaks in the 2020s and for oil demand in transport that peaks in the 2030s. In both cases demand declines rapidly after the peak – see Figures 1 and 2. The reductions in demand are on a large enough scale potentially to create supply surpluses, depress fossil fuel prices and undermine the investment case for high-cost, long-life extraction projects. These simple projections suggest that on a timescale of a decade or so fossil fuel assets are vulnerable to being stranded by competition from renewables and electric vehicles. Further regulations to reduce emissions will only accelerate this technological stranding. Provided that investors, insurers and lenders take this possibility seriously and monitor progress towards it they can adjust their portfolios so that the beginning of a steady decline in fossil fuel use does not surprise them.

In time, fossil fuel companies will begin to adjust to the unavoidable long period of declining demand that lies ahead. Those with the lowest cost reserves will preserve value for shareholders by managing themselves to maximise cash-flow during this period. Others will seek economies through mergers and acquisitions. In any event, the downside risk for the industry will increase significantly until it has adjusted itself to the coming changes.

Climate Risks

The future depicted in Figures 1 and 2 may seem to be technologically optimistic. Although fossil fuel use for generation and transport decline rapidly after the peak, these only account for around half of aggregate fossil fuel use. In the absence of stricter regulations, total fossil use only declines slowly, so that damage to the economy from warming continues to be a significant systemic risk.

Systemic Risk

A simple calculation illustrates the scale of the systemic risk to the financial system from climate change. According to elementary finance theory, the value of a financial asset is the present value of its expected future income, calculated using a market discount rate. It follows that the value of a stream of dividends that grows steadily from unity is approximately the reciprocal of the difference between the discount rate and the growth rate. In the very long term, dividends from a well-diversified portfolio might be expected to grow at the same rate as the world economy, all other things being equal. If the world warms by several degrees, the rate of growth of world gross domestic product (gdp), and therefore of dividends, may be reduced compared to what they would have been without warming.

Suppose, for example, that in the absence of warming the world economy is expected to grow at 2.5% a year, but that economic damage from warming in a ‘plausible worst case’ brings growth to a halt before 2100. If this happened in the mid-2080s then by 2100 world gdp would be 30% less than it would have been without warming. The net effect would be to reduce to 2.1% the average expected growth rate to 2100. A typical long-term discount rate used by investment analysts for discounting dividends might be 6.5%. The consequence is that the value of a portfolio would be 10% lower if economic damage of this magnitude were expected than if it were not. This is the contingent value reduction or ‘impairment’ due to future climate damage.

Climate Risks

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