We may think we know what real eco­nom­ic volatil­i­ty looks like, hav­ing wit­nessed the effects of the Covid-19 pan­dem­ic and, back in 2007-08, the glob­al finan­cial cri­sis. But we’ve seen noth­ing yet. Imag­ine a time when sev­er­al cli­mate risks come to pass in quick suc­ces­sion, result­ing in a series of nat­ur­al dis­as­ters around the globe. This could spark a col­lapse in mar­ket sen­ti­ment and asset val­ues, with a mas­sive repric­ing of risk and a spike in bor­row­ing costs. 

This would be a so-called Min­sky moment, a term coined by US econ­o­mist Paul McCul­ley in mem­o­ry of one of his key aca­d­e­m­ic influ­ences, the late Hyman Min­sky, to describe the point at which a num­ber of fac­tors com­bine to end an unsus­tain­able peri­od of bull­ish spec­u­la­tion and cause a crash.

Mark Car­ney, the for­mer gov­er­nor of the Bank of Eng­land – a man not known for over­state­ment – warned of the pos­si­bil­i­ty of a cli­mate-induced event of this kind in 2015. 

Giu­lia Chris­tian­son is direc­tor of sus­tain­able pri­vate-sec­tor finance at the World Resources Insti­tute, a not-for-prof­it research organ­i­sa­tion. She agrees that “the cli­mate cri­sis could absolute­ly induce a finan­cial cri­sis. The onset of the pan­dem­ic gave us a glimpse of how an unfore­seen shock can shut down economies, crip­ple sup­ply chains and cause intense volatil­i­ty in the finan­cial mar­kets.” 

It’s hard to assess risk in mar­kets when very lit­tle high-qual­i­ty infor­ma­tion is being shared. Research by the Car­bon Dis­clo­sure Project (CDP) in 2020 found that the com­bined car­bon foot­print of all the firms in the invest­ment port­fo­lio of the aver­age finan­cial insti­tu­tion was 700 times larg­er than the company’s own foot­print. Yet only a quar­ter of the 332 finance providers in the study said that they rou­tine­ly report­ed on the emis­sions records of their investees, while 49% admit­ted that they “do not con­duct any analy­sis of how their port­fo­lio impacts the cli­mate at all”.

The CDP’s glob­al direc­tor of pol­i­cy engage­ment and exter­nal affairs is Pietro Bertazzi. He observes that both finan­cial insti­tu­tions and their investees are “fail­ing to gath­er an accu­rate depic­tion of their impacts and the risks posed by the cli­mate cri­sis. This leads to a much high­er poten­tial of reach­ing a cli­mate Min­sky moment, includ­ing a greater like­li­hood of strand­ed assets. The cur­rent reg­u­la­tion of envi­ron­men­tal dis­clo­sure is not suf­fi­cient.” 

Busi­ness­es are there­fore sleep­walk­ing into a world that will be far warmer than the tem­per­a­ture tar­get set by the Unit­ed Nations (1.5ºC above pre-indus­tri­al lev­els) in its Paris agree­ment of 2016. If this risk is not enough to moti­vate the mar­kets, the prospect of los­ing bil­lions of pounds in anoth­er finan­cial cri­sis just might be. 

In Sep­tem­ber 2021, the Bank of Inter­na­tion­al Set­tle­ments issued a warn­ing about the risk of a bub­ble in the sus­tain­able finance mar­ket. Gov­ern­ment bonds are also heav­i­ly exposed to cli­mate risk.

“Despite being in a mul­ti­tril­lion-dol­lar mar­ket, investors have his­tor­i­cal­ly lacked the tools need­ed to hedge cli­mate risk in sov­er­eign bonds,” says David Har­ris, glob­al head of sus­tain­able finance at the Lon­don Stock Exchange Group. 

Giv­en the scale of the prob­lem, there is a grow­ing con­sen­sus that the report­ing of cli­mate risks should be manda­to­ry, not vol­un­tary, in all juris­dic­tions. This would arm investors with more data, says Cindy Rose, head of respon­si­ble cap­i­tal­ism at Majedie Asset Man­age­ment.

But she adds that “investors need to know how to inter­pret this prop­er­ly. It’s not just hav­ing the data that’s impor­tant; it’s what we do with it that mat­ters. In the end, though, I hope that the mar­ket will be able to make bet­ter invest­ment deci­sions.” 

At this point there is no large body of evi­dence to indi­cate that cli­mate risks could bring down the whole finan­cial sys­tem. Much depends on new com­mit­ments by gov­ern­ments to slash emis­sions through mea­sures such as tax­a­tion. The UN’s COP26 cli­mate con­fer­ence in Glas­gow could shed some light on mem­ber states’ inten­tions. This would give mar­kets some of the con­fi­dence they require to man­age the risk sen­si­bly over time. 

The finance sec­tor tends to treat cli­mate change as a chron­ic con­di­tion rather than an acute one, but a rapid suc­ces­sion of nat­ur­al dis­as­ters could spook the mar­kets. Beyond this fac­tor, there are so-called tran­si­tion risks. These occur when gov­ern­ments enact tougher poli­cies and their economies can’t adjust quick­ly enough to these. There are signs of this in Chi­na and the UK. 

“We have ris­ing ener­gy demand, yet a lack of viable alter­na­tives to fos­sil fuels, as well as slow green pol­i­cy devel­op­ment by gov­ern­ments. This heady com­bi­na­tion not only wors­ens our longer-term warm­ing sce­nario; it also points to the pos­si­bil­i­ty of a more severe finan­cial fall-out,” Rose says. “Ide­al­ly, gov­ern­ments would work togeth­er on this, but the world is so fac­tious that it makes col­lab­o­ra­tion dif­fi­cult. There may be some ele­ments of a Min­sky moment that are unavoid­able, sim­ply because peo­ple refuse to take respon­si­bil­i­ty or work col­lec­tive­ly.”   

It shouldn’t be this way. The release of tonnes of atmos­phere-warm­ing methane from inten­sive beef farm­ing in one coun­try, for instance, could affect the cli­mate of anoth­er thou­sands of miles away. All mar­kets, busi­ness­es and peo­ple are con­nect­ed when it comes to cli­mate change. The prob­lem there­fore requires coun­tries to work in con­cert to find a solu­tion. 

“The way gov­ern­ments gal­vanised them­selves into action for the Covid cri­sis has not been repli­cat­ed in the case of the cli­mate cri­sis.” reports Mona Shah, head of sus­tain­able invest­ments at Stone­hage Flem­ing. “Action on the cli­mate cri­sis is lack­ing because it has not been coor­di­nat­ed glob­al­ly. Gov­ern­ments need to gal­vanise them­selves into pur­su­ing a set of sys­tem­at­ic actions, rather than sim­ply set­ting their coun­tries emp­ty tar­gets for future car­bon neu­tral­i­ty.”

She con­tin­ues: “Gov­ern­ments also need to con­duct deep research to under­stand the vul­ner­a­bil­i­ty to GDP growth at each half-degree of glob­al warm­ing and at a sec­tor-by-sec­tor lev­el. This under­stand­ing can then be used to dri­ve actions for every indus­try con­cern­ing car­bon reduc­tion and off­set­ting. It seems to me that we are all suf­fer­ing from politi­cians’ cog­ni­tive dis­so­nance, even though the envi­ron­ment is increas­ing­ly becom­ing a vote-win­ning issue.”

When there is a poor pic­ture of how the cli­mate evolves and affects the world’s man-made assets over time, there could also be prob­lems. Mod­el­ling this lev­el of com­plex­i­ty is a real chal­lenge, accord­ing to Stephanie Maier, glob­al head of sus­tain­able and impact invest­ment at GAM Invest­ments. 

“We’re deal­ing with a lot of uncer­tain­ty – uncer­tain­ty about cli­mate pol­i­cy; uncer­tain­ty about the role of exist­ing and future inno­va­tion; and uncer­tain­ty about com­pa­nies’ com­mit­ment and abil­i­ty to tran­si­tion,” she says. “Are we going to avoid a cli­mate Min­sky moment? It is too ear­ly to know.” 

So, what is being done to avert this moment? There are some pos­i­tive trends. The grad­ual pric­ing of car­bon risk into glob­al mar­kets is occur­ring and will at least con­tin­ue over the medi­um term. Cli­mate report­ing is com­ing on in leaps and bounds – it’s becom­ing increas­ing­ly reli­able, pro­vid­ing more infor­ma­tion about emis­sions through­out a company’s glob­al sup­ply chain, as well as on the firm’s direct emis­sions and ener­gy con­sump­tion. Busi­ness­es are also adopt­ing sci­ence-based tar­gets apace. 

All this is enabling more ESG-relat­ed data to per­co­late up into board­rooms, where it can be used for strate­gic deci­sion-mak­ing pur­pos­es. This is where it will make a real dif­fer­ence. The key to an order­ly tran­si­tion for finan­cial insti­tu­tions is engage­ment with the com­pa­nies they finance and vice ver­sa, in con­ver­sa­tions where every­one is empow­ered by infor­ma­tion. 

“The trans­par­ent shar­ing of envi­ron­men­tal impact data is crit­i­cal to tack­ling the cli­mate cri­sis,” Bertazzi says. “We’re now see­ing a sig­nif­i­cant momen­tum in cor­po­rate action. In 2020, for instance, we had record num­bers of com­pa­nies dis­clos­ing their envi­ron­men­tal data via CDP.” 

This groundswell of infor­ma­tion, action and reac­tion con­cern­ing green­house gas emis­sions, decar­bon­i­sa­tion and ener­gy con­sump­tion should help cap­i­tal providers to for­ti­fy mar­kets, price in risk and finance change. Will it be enough to stave off a Min­sky moment? Only time will tell. 

The case for mandatory environmental reporting across the board

We are still in the ear­ly days of devel­op­ing inter­na­tion­al­ly recog­nised stan­dards that incor­po­rate cli­mate-relat­ed impacts into finan­cial accounts. Yes, report­ing stan­dards are on the rise, but so too is the vol­ume of cor­po­rate emis­sions data and cli­mate-relat­ed dis­clo­sures. But full report­ing of cli­mate risk isn’t uni­form across the globe yet. And account­ing for sup­ply chains world­wide is anoth­er issue.

“Car­bon account­ing has been manda­to­ry in the UK for list­ed com­pa­nies since 2013 and is now stan­dard prac­tice in most devel­oped coun­tries, includ­ing the US, for quot­ed firms,” explains Lucian Pep­pe­len­bos, cli­mate strate­gist at Robe­co. “It does, though, need to be adopt­ed more wide­ly by all com­pa­nies out­side the stock mar­kets. This may be dif­fi­cult for small­er unlist­ed busi­ness­es, for which the process remains vol­un­tary.”

To date, dis­clo­sures on cli­mate risk have large­ly been shaped by the mar­ket in a trend that could be termed ‘pre-reg­u­la­tion’. It means that there is now a de fac­to cost of access to cap­i­tal mar­kets in many regions. Com­pa­nies have to invest more on the ESG front to access funds. 

The EU has leg­is­lat­ed in this area with its car­bon bor­der adjust­ment mech­a­nism, a com­plex sys­tem that impos­es a levy on spe­cif­ic imports. This will affect main­ly high-emis­sion coun­tries, such as India and Chi­na, but more needs to be done. 

“Reg­u­la­tion on envi­ron­men­tal dis­clo­sure increas­es trans­paren­cy and would help to accel­er­ate the sus­tain­abil­i­ty trans­for­ma­tion of cap­i­tal mar­kets and economies, which is urgent­ly need­ed to com­bat the envi­ron­men­tal cri­sis,” says Pietro Bertazzi of the CDP. “There’s also an urgent need for con­sis­tent, com­pa­ra­ble, com­plete and con­firmable report­ing. Yet 2021 marks a turn­ing point for stan­dards. The scene is set for a uni­fied glob­al com­pre­hen­sive report­ing sys­tem, led by the Inter­na­tion­al Finan­cial Report­ing Stan­dards Foun­da­tion. This is a very wel­come devel­op­ment. A manda­to­ry dis­clo­sure sys­tem would cre­ate reg­u­la­to­ry cer­tain­ty, which would push those that do not cur­rent­ly dis­close vol­un­tar­i­ly to do so.”

Whether the UK needs a cli­mate-report­ing watch­dog to ensure com­pli­ance remains to be seen. No one in indus­try likes the heavy hand of reg­u­la­tion bear­ing down on them. Politi­cians are talk­ing about cut­ting red tape to spur low-car­bon inno­va­tion, not about cre­at­ing more. The issue is whether finan­cial mar­kets are doing enough suf­fi­cient­ly quick­ly.  

“It’s not that we need a new set of reg­u­la­tors for dif­fer­ent mar­kets. We need exist­ing reg­u­la­tors to main­stream cli­mate change into their man­dates and activ­i­ties,” argues Giu­lia Chris­tian­son of the World Resources Insti­tute. “This requires lead­er­ship and polit­i­cal will, as well as new capac­i­ty and know-how. But it can and should be done –soon­er rather than lat­er.”

It is like­ly that, as report­ing becomes impor­tant enough to the mar­kets, investors and the pub­lic, more over­sight will be put in place to ensure that the rules are respect­ed.