The Bank of England will be the first central bank in the world to stress test its financial system against different climate pathways, while Australia’s financial regulator has no immediate plans to introduce stress-testing despite the mounting effects of climate change.

Bank of England Governor Mark Carney recently said climate change “will prompt reassessments of the values of virtually every financial asset”. 

The Bank of England will be “the first regulator to stress-test its financial system against different climate pathways,” Carney said. Those pathways will include “the catastrophic business as usual scenario and the ideal—but still challenging—transition to net zero by 2050 consistent with the UK’s legislated objective”.

The US central bank will not carry out the tests until 2021, when it will have had time to develop its different scenarios. The central bank will examine which financial firms have strategies for the transition to a “net zero” carbon emission economy, which firms are gambling on new technologies or government inaction, and which ones have yet to consider the risks and opportunities.

But the Australian Prudential Regulation Authority (APRA) says it is not stress-testing the financial system, despite evidence of a harmful effect on some assets. “We have no immediate plans to stress test banks specifically on climate change,” APRA told Morningstar.com.au this week.

Yet the Reserve Bank of Australia’s Financial Stability Review recently pointed to falling asset values as a direct result of climate change, which could compromise banks’ and insurers’ balance sheets. 

“The physical effects of climate change can have a significant impact on Australian financial institutions,” the RBA said.

“Assets that are exposed to increasing physical risk (such as property located in bushfire-prone or coastal areas) could decline in value, particularly if these risks become uninsurable,” the central bank said. 

Banks and other lenders face risks because climate change “can result in a decline in the income or value of collateral that they are lending against. Such effects can go beyond the industries directly affected by climate change (such as agriculture and tourism), to the households and businesses that rely on income from those industries,” the RBA said.

Carbon price ‘will help markets adapt’

Kate Howitt, portfolio manager of Fidelity Australian Opportunities Fund, says a predictable carbon price would allow capitalism and markets to do what they do best:  adapt to change in the most economically efficient way. 

“But with Australia’s current policy gridlock, the impacts of climate change will probably be priced in later, in more dramatic lumps.  This will add to the volatility experienced by Australian investors and retirees,” she said.

“There will clearly be costs to adaptation - but the sooner we get on with it in an organised way the lower the overall costs to corporate Australia - and the better the returns to Australian retirees who are the ultimate owners of corporate Australia,” she said.

AMP Capital ESG Investment Researcher, Camille Wynter, agrees. Climate change is exposing financial institutions to risks that will likely worsen over time, if not addressed now. 

“For example, in lending and underwriting we expect to see decreasing exposure to the fossil fuel industry in their lending books and increased focus on the risk of stranded assets. Banks will also have to revalue their loan books due to changes in property values after the physical impact of climate change is considered,” Wynter said.

Insurers have been affected already. As an example, inflation-adjusted insurance claims for natural disasters in the current decade have been more than double those in the previous decade. 

“This impact is likely to grow over time,” the RBA said.

AMP’s Wynter expects to see more insurers undertake deeper analysis on the possible physical damages to residential homes and commercial assets from more severe storms or bushfires before insurance is provided. 

“Climate change is rising up the public agenda and the number of court cases against companies for failing to disclose climate risks is increasing around the world. We have seen also seen large Australian insurers be the target of climate change-related shareholder resolutions this year.

“It is evident that public interest and activist pressure is increasing and will continue to do so in the coming years.”

Role for central banks

According to a recent report from UBS, Time to evolve: A quarter-century of FX reserve management, central banks “might be seen as ideal vehicles to enforce a climate risk agenda by exercising pressure via investment decisions” since they have vast amount of assets and foreign exchange reserves.

As politicians start to “feel the heat” from the next generation of voters protesting in the streets and green parties winning big in European elections, “the chances increase that the investment policies of state institutions could be seen as levers to make an impact,” write the report authors Massimiliano Castelli and Philipp Salman of UBS Asset Management.

They say international cooperation will be key and will largely define the effectiveness of the global response of central banks to climate change.

“By far the most important policy initiative that has developed over the past years is the Central Banks and Supervisors Network for Greening the Financial System (NGFS). Currently comprising more than 30 central banks and regulators [including the RBA], it carries the aim of contributing to financial stability by stepping up the efforts 24 needed to achieve the targets of the Paris Climate Agreement.” 

Opportunity for investors

Michael Baldinger, the head of the sustainable and impact investing team at UBS, says that among larger institutional investors, increasing awareness of climate change is leading investors to seek strategies which address the issue from a risk-mitigation perspective and greater engagement with companies themselves about their carbon emissions. 

“Our Climate Aware strategy, for example, launched in 2017, now has over $2 billion in assets under management and is supported by a collaborative engagement program with the Climate Action 100+ initiative and has led to concrete commitments for carbon emissions reductions at some of the largest and most carbon-intensive energy companies globally. 

“Increasingly, investors are looking for strategies that demonstrate actual impact and therefore make a difference in addressing the climate change issue directly,” he says.

But wills such strategies be profitable? Like any strategy, there will be opportunities and pitfalls, says Fidelity’s Howitt.

She says that an eventual regulatory imperative on climate change could provide a revenue support to emerging technologies, but also offers a warning.

“However, this positive effect can easily be swamped by a deluge of new capital entering the space.  This was often the case with investments into wind power where wind was heavily subsidised.  

“The results for investors were often not pretty.  So, adapting to climate change will throw up the same investment opportunities and risks - and require the same skill and discipline - that are necessary with all investments.”