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The Effects of Climate Change in the Financial Industry

Introduction

Climate change is an emerging global concern that has massive implications on the functioning of the entire society. Besides affecting the social wellbeing of humans, the effects of climate change influence the political and economic spheres too. The financial industry is at the core of the global economy. Specifically, financial institutions play an instrumental role with respect to providing the global population with capital and identifying as well as managing investment related risks and opportunities. These are vital aspects that influence decision making and general operations in the financial sector and the economy at large. As indicated earlier, climate change is an important phenomenon that presents both risks and opportunities for exploration in by the financial industry. According to Labatt and White (2007), the effects of climate change on this sector can be either indirect or direct. Since financial institutions are at the center stage of the global economy, the effects of climate change that affect them spill over to the economy too. In order to minimize risk and seize opportunities in a timely manner, it is important for the financial industry to understand the nature of the direct and indirect effects of climate change. It is against this background that this paper provides an in-depth evaluation of the effects of climate change in the financial industry.

Climate Change Events that Affect the Financial Industry

Climate change is characterized by extremes in weather events and temperatures. Oxley (2012) indicates that global warming results into hot and lengthy summers. Increased temperatures have direct effects on crop and animal production and business operations. In addition, it affects land subsidence as well as mortality and morbidity trends amongst humans. The changes in air quality are caused by rising temperatures and have direct impacts on human and animal health. The effects of the rising temperatures influence decision making of financial institutions in different ways. Cold temperature extremes are likely to become rare due to global warming (Rudyk, Stewart & Kingsbury, 2009).  In temperate regions, these changes have positive impacts on various sectors including construction, and transport. In addition, the changes are unlikely to have any noticeable effect on business operations. Although the temperatures are unlikely to remain low, changes in precipitation will be expected. Thus, incidences of heavy snow fall, severe storms and flooding will rise. Heavy rainfall and flooding culminate in various economic losses that have diverse implications on the financial sector.

Global warming leads to low rainfall and increased incidences of wildfire and drought (Mills, 2009). This affects the financial industry because of the impacts that it has on building foundations and commercial agriculture. The risks that relate to the abovementioned hazards affect decisions and operations in the financial sector directly. Also, extra tropical and tropical windstorms are likely to be experienced more often due to climate change (Mills, 2009). Undisputedly, the damages that are associated with these events are significant. They impose immense pressure on human health, resources, and infrastructure. Finally, the rise in sea level causes flooding and increases the occurrence of tidal surges. The losses of property and lives that are associated with this event are enormous. The financial industry assumes the responsibility of managing the losses, repairing infrastructure and compensating institutions and individuals accordingly.

Climate Change and the Banking Sector

In his research, Bowman (2013) indicates that banks play a leading role in helping the population to adapt to the implications of climate change. By developing risk mitigation products, lending individuals and institutions financial resources during critical times, formulating credit risk management policies, and making vital investment decisions, banking institutions empower populations to adjust effectively to climate change. The impacts of climate change to the banking sector are both negative and positive. In addition, they are both direct and indirect and impose costs as well as provide opportunities for the banking institutions.

Climate change has direct impacts on project financing as well as corporate banking (Bowman, 2013). To begin with, the current policies that relate to mitigation of climate change expose banks to credit risk. In particular, policies that aim at reducing emission of greenhouse gases transfer business risks to the global economy. The regulations undermine the credit worth of carbon intensive institutions and therefore expose banks to related risks because the banks play an important role of financing the affected institutions. In addition, the banks share a mutually benefiting relationship with the institutions and as such, any financial challenges that face the institutions have spillover effects on the banks. The policies’ costs of compliance affect the companies as well as consumers of their products. The affected sectors such as the energy industry and cement manufacturers struggle with additional costs that have negative effects on their financial stability. This has implications for banks that play important roles as project financiers, lenders, and equity investors (Bowman, 2013).

Further, banks face various operational risks that stem from poor internal risk assessment processes. In most instances, these culminate in inappropriate evaluation of carbon related impacts. In some instances, Rudyk et al. (2009) argues that poor risk evaluation is influenced by the volatile nature of the carbon related policies. Inappropriate risk management by affected firms results into financial sanctions that have far reaching effects on the financial wellbeing of the affected institutions. In particular, such incidences affect the liquidity of the clients adversely and compromise the credit worth as well as competitiveness of the banks too.

Directly, the effects of climate change such a severe storms and flooding have negative impacts on corporate assets and real estate. In his review, Bowman (2013) estimates that severe weather destroys corporate assets of worth 3,800 billion US dollars each year. In addition changes in weather patterns result into uncertainty in the utility sector. The changes increase the costs of energy that are used by the corporate buildings that are occupied by the banks. As indicated earlier, mitigation policies impose additional costs to banking institutions and other parties in the financial sector. Noncompliance to them has severe repercussions including blacklisting. Resultantly, this has detrimental effects on the reputation of the affected institutions as well as on their ability to access and benefit from credit.

In addition, investing in controversial energy projects such as nuclear power exposes banks and their clients to reputational risks (Oxley, 2012). In this regard, it is worth appreciating that the current consumer base place great emphasis on environmental protection and restoration. Association with controversial projects has negative effects on the sustainability of banks. It influences the decisions, operations, and perceptions of clients negatively. What is more, the policies require banks to participate actively in corporate social responsibility activities relating to environmental protection. Relative initiatives require financial resources and intensive capacity building (Oxley, 2012).

Labatt and White (2007) posit that the effects of climate change also present financial institutions with opportunities for sustainable growth and development. In this respect, adaptation of corporate institutions to the changing energy environment and compliance with the policy regulations presents banks with opportunities for growth because the initiatives require financial involvement. Specifically, the affected sectors require low carbon technologies and purchase of renewables. Banks can explore these opportunities and ensure that they reap optimal outcomes. However, Labatt and White (2007) argue that it is important for them to understand the long term risks that may be related to the investments.

At this point in time, it cannot be disputed that climate change has diverse effects on the poor facet of the population. The effects cause them to seek for financial resources in order to protect themselves against the negative impacts of future occurrences and repair damages that are associated with the same. These present banks with opportunities to offer innovative microfinance services. Besides providing the affected population with financial resources, banks offer a broad array of products including savings and insurance.

Climate Change and the Insurance Sector

The effects of climate change are likely to have massive implications on the activities and operations of insurance firms. Essentially, professionals in this field are responsible for investigating risks including those that are related to climate change. Recent trends indicate that seemingly, insurance firms are incurring increased costs that relate to damages caused by the effects of climate change such as severe storms and flooding (Oxley, 2012). The effects of climate change compromise the ability of insurance firms to draft their terms as well as prices effectively. In this respect, the firms rely on historical trends to make future predictions. However, the dynamic nature of the climate changes has made historical statistics unreliable and therefore irrelevant. In this sense, the uncertain nature of climate change projections makes it difficult for insurance firms to make accurate risk assessments. This has massive implications on their ability to value future losses.

The effects of climate change have direct impacts on matters that are covered by both non-life and life insurances. In this respect, Mills (2009) cites that extreme weather conditions damage infrastructure, natural resources such as farmlands, and material property. As the temperatures rise, it is likely that mortalities and health complications that are related to hot weather will become more popular. On the other hand, health complications and deaths that result from cold weather are likely to decrease. In addition, these health complications are more likely to affect the chronically ill and elderly members of the society as opposed to the young and healthy groups. Regardless of the preceding dynamics, it is worth noting that it is very difficult to change the provisions of long term insurance contracts including life insurance in line with the changing risks and weather conditions in the course of the policy term. Undoubtedly, such policies pose significant challenges for insurance firms. Directly, the effects of climate change such as severe storms destroy the investment targets that they have and thus, damage their capital funds (Mills, 2009).

The extreme weather conditions that characterize climate change make insurance companies to incur additional costs. Research evidence indicates that the losses that relate to non-life insurance caused by extreme weather conditions impact negatively on the performance of the insurance companies (Mills, 2009). Reportedly, weather related catastrophes have quadrupled in the last fifty years. The monetary costs that are associated with the catastrophes have risen significantly too. The costs are attributed to the rising value of the properties as well as amount of the insured property and materials. Furthermore, the buildings and housing centers that are insured have been concentrated in areas that are prone to weather related risks. Future predictions show that the severity and complexity of climate change related catastrophes is likely to increase. This implies that the costs that are related to weather related damages are likely to double. These trends have made insurance companies in the affected regions to cease business operations. The trends undermine their ability to operate profitably.

The legal action that is taken against polluters and companies that emit greenhouse gases also affect insurance companies in different ways. In this respect, the firms incur expenses that relate to secondary obligations. This occurs when their clients are found to be responsible for the negative effects of climate change. Ideally, the firms with legal expenses insurance transfer the related costs to insurance companies. In some instances, these costs are massive and undermine the profitability of the affected companies (Rudyk et al., 2009). The versatility of the risks that they assume liability for forces insurance companies to increase their capital. This is in an effort to finance their operations as well as realize profits. Regularly, insurance companies raise their premiums in a bid to restore their solvency after they have incurred significant costs including those that relate to weather variations. In some countries, legal provisions prohibit insurance companies from adjusting their premiums up to a certain limit. This implies that the firms in the affected regions cannot adjust their premiums and are forced to shoulder the losses. Further, laws in certain countries prohibit cancellation of insurance policies. Likewise, the firms in the regions are forced to incur huge losses.

Due to the increased risks that are caused by the effects of climate change, insurance companies seem to be returning the burden of risks to policy holders. The current trend poses significant challenges to both insurance and reinsurance companies with respect to managing their own risks. Seemingly, policy holders are likely to face new challenges that relate to higher premiums and lack of certain insurance policies. In response to the increasing complexity of risks, insurance companies are tightening their contractual terms and are making extensive demands (Labatt & White, 2007). These strategies are aimed at enabling them to deal with the losses and damages effectively. Policy holders are likely to resort to other adaptation measures due to these tightening conditions. Research evidence shows that higher premiums cause people with limited means to relocate from high risk areas because of their inability to afford insurance (Oxley, 2012). In other cases, they stay in the affected regions without the security that insurance provides.

Discussion of Findings

Global warming has direct effects on weather conditions and contributes significantly to an increase in catastrophic occurrences. Financial institutions play a pivotal role of spreading the costs that relate to these events to all facets of the population. Through their operations, they ensure that all individuals share in the costs that relate to damages caused by these events. Recent trends ascertain that the occurrence of catastrophic events has increasingly become unpredictable. In addition, the severity and complexity of the effects of climate change continue to increase to worrying levels. The changes have various implications for the financial sector. Certainly, they present new and unique challenges that financial institutions are supposed to address. The additional costs have various effects on the operations and general wellbeing of the financial industry.

Directly, the weather events including increased precipitation and extreme temperatures destroy infrastructure, physical assets of both the financial institutions and their clients, and real estate. Admittedly, the economic losses that relate to the damages are significant. Generally, the losses that relate to extreme weather events can destabilize the operations of the insurance sector. Coupled with the recognition that the value of the insured physical properties continues to increase, this presents new challenges for the insurance sector. Elevated client prices, increased incidences of withdrawal from insurance, increased demand for compensation by institutions and members of the public, and the complexity and uncertainty that surround the occurrence of natural calamities increase the vulnerability insurance companies. In addition, the changes complicate the adaptation efforts and compromise the overall profitability of these financial institutions.

Also, the weather changes have diverse effects on life, natural resources, savings, and human health. The changes have various implications on insurance policies such as life insurance. With respect to savings, the incidents reduce the disposable income of populations and make it difficult for insurance companies to operate profitably by selling the policies. As identified in the findings of this study, the events also lead to higher premiums. The weather related disasters also offer lucrative opportunities for exploration by financial institutions. For instance, the events increase the demand for insurance of material property and health cover. In addition, they lead to emergence of new market due to technological changes. These can be exploited by financial institutions in order to foster sustainable growth and development. However, they face the challenge of evaluating the long term effects of the opportunities in order to determine their viability. Generally, the effects of climate change on the financial industry are immense. Future research in this regard should focus on sustainable ways that institutions in the industry can use to address the changes effectively.

Conclusion

The effects of climate change affect all facets of the society including the social, environmental, health, and economic spheres. Financial institutions are at the core of the global economy and their operations, decisions, and activities influence growth and development in different ways. Weather related events that result from climate change and which impact on the financial sector range from extreme temperatures to changes in precipitation. In the banking sector, climate change impacts significantly on project financing investment banking, asset financing, project financing, and retail banking. In addition to reducing the competitiveness of clients that emit high volumes of greenhouse gases, involvement in controversial projects harms the reputation of banks. In addition, the banks incur direct losses due to damage of physical property and policy changes. The insurance industry struggles with higher premiums, increased losses due to damage of property, infrastructure and increase in number and severity of fatalities. Nonetheless, the events also provide lucrative opportunities that financial institutions can explore in order to maximize profits and sustain growth.

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