Unprepared, the financial system will triple people’s bills for climate change

The first bill: the physical impacts of fossil finance

Despite the Paris Agreement, world governments and the financial system are failing to phase out fossil fuel finance. Climate change is accelerating, and the destruction from fires, floods, droughts, and hurricanes is reaching levels that even scientists didn’t expect.

People are at the frontline, their families, houses, and health exposed. But for the victims, this new normal of climate destruction from extreme weather events is only a beginning.

A second bill to make up for unprepared insurers

The underinsurance of the climate damage costs can double down into a financial disaster for the victims. With the ballooning costs of climate impacts, a growing proportion of households is seeing their insurance prices skyrocket and the coverage of their policy shrink.

Entire parts of the world are becoming uninsurable as insurance companies preemptively withdraw coverage, leaving homeowners helpless against mounting natural catastrophes and confronted with devalued or unsellable properties.

The first business failures due to climate risk have already occurred, and there is a real risk that insurance companies will be unable to face the cumulative cost of claims on insured damages, leaving policyholders to foot the bill or the public to manage — i.e. transferring the costs to consumers and taxpayers.

Interconnectedness and “system-wide amplification”

The insurance sector is but the tip of a climate risk iceberg. Insurance companies are tightly interconnected with banksInsurers are interconnected with banks through equity investment, credit claims and the provision of liquidity and collateral. Read the analysis by the European Central Bank here and the spiraling cost of natural catastrophes risks spilling over from the insurance to the banking sector, which threatens financial stability.

But there is more. Insurance coverage is a precondition for resilient economic development. When insurance becomes unavailable or unaffordable, it can disrupt economic activity in entire regions, as banks withdraw lending. Property values fall, businesses postpone investments and downsize workforces, financiers retreat, and markets panic. This destructive feedback loop, what banking supervisors call a “system-wide amplification effect” (Finance Watch calls it a “disruption risk”), can suddenly expose the whole financial system to massive lossesOn top of the exposures of banks to a regional drop in property and business value, and on top on their interconnection with the insurance sector through equity investment and credit claims, banks are also interconnected with insurers through a common exposure to assets. Distress in the insurance sector or a whole region’s economy give rise to asset fire sales, which depress the prices of assets held by other financial actors, adversely impacting their solvency..

“Fossil subprimes” across the financial system

Banks and insurers are among the biggest funders of the fossil fuel industryBanks and insurers are among the biggest funders of the fossil fuel industry through their underwritings, investments and lending. For the discussion on insurance sector exposures to fossil fuel, see the Finance Watch report “Insuring the uninsurable”. For the banking sector, see the Finance Watch report “Report – A safer transition for fossil banking” — the primary cause of current climate change. By providing insurance coverage and financing for fossil fuel projects, they contribute to the build-up of systemic climate-related risksSystemic risk underpins macroprudential supervision, which aims to enhance the resilience of the financial system resilience to shocks that risk triggering the collapse of entire industries or economies. Climate change is now widely recognized as a major systemic risk to financial stability. Fossil fuel finance exacerbates climate change, which in turn threatens financial stability—creating a “climate-finance doom loop.” Finance Watch coined this term in 2020, advocating for higher risk weights on fossil fuel exposures in the banking sector using existing prudential tools in the Capital Requirements Regulation. Read more in our report across the entire financial system. This creates a dangerous feedback loop which undermines the stability of the financial system.

Meanwhile, an erratic transition to “net zero” is taking place as the world is unevenly shifting away from carbon-intensive activities, and towards new energy mixes. Financial institutions’ entanglement with the fossil fuel industry inevitably exposes them to the increasing risk of the devaluation of fossil fuel-related assets“Transition risks” refer to the financial risks related to shifting to a low carbon economy, including policy, legal, technological, and market changes. Fossil fuel related assets face higher exposure to these risks. Financial regulators now widely recognize transition risks, with the top European insurance supervisor urging increased capital buffers for insurers holding such assets. During this transition, countless policy, legal, technology, or market changes could trigger a sharp repricing of fossil fuel assets, potentially creating a new class of “subprimeSubprime mortgages are known for their contribution to the 2008 financial crisis. Read more here” assets – “fossil subprimes” – subject to rapid and destabilising devaluation.

Illustration: The feedback loop created by banks’ financing of fossil fossil assets is dangerous for financial stability

The third bill: taxpayer-sponsored bailouts

All the ingredients for a perfect financial storm are here, on top of the climate crisis itself. But big banks and insurers are too important to our economy for governments to let them fail: political leaders are more likely to spend people’s money bailing out these institutions than letting them go bankrupt and risk another financial crisis. These financial institutions are what supervisors call “too big to fail”; they put the economic system in a situation of moral hazardWhen economic actors do not have to bear the risk they take (fossil finance) and effectively transfer it to the society (taxpayers bailout), economists call this a “moral hazard”. It is the case with risks taken by “global systemically important financial institutions” whose list is kept up to date by global financial authorities like the Financial Stability Board. It is also the case for other systemically important financial institutions, see on the ESRB website. where taxpayers are held hostage by private actors’ excessive exposures to risk.

As a consequence, on top of direct climate damages and uninsured losses, citizens might have to pay a third time for fossil finance. This time by bailing out the too-big-to-fail financial institutions that are unprepared for climate risk.

Protecting people from systemic risk

The good news is: financial supervisorsFinancial supervisors are public authorities whose role is to ensure the proper implementation of financial regulation. Goals of financial supervision are, among others, to maintain confidence in the financial system, to maintain financial stability, to protect consumers of financial services, to reduce financial crime and to regulate foreign participation in local financial markets. know how to reduce moral hazard and they have a mandate to make sure financial institutions can withstand the losses related to their risk exposures.

In the longer term, policymakers have to structurally reformStructural reforms of the financial system include a separation of commercial banking activities and investment banking activities into different entities (read Finance Watch explanations on this). Alongside bank separation, there is a need for an effective recovery and resolution regime for financial institutions (read the report Ten Years After: Back to Business as Usual), simpler rules on internal modeling of risk in banking rules (read the report Lost Momentum: The Evolution and Challenges of Basel III), and a solid regulation of shadow banking and its interconnection with the banking system. the banking and insurance sectors to eliminate moral hazard and prevent these institutions from becoming “too-big-to-fail” altogether. But until this is achieved, the fastest and most efficient way for supervisors to tackle this build-up of climate risk is to adapt their prudential toolsIn order to protect financial stability and avoid turmoil such as financial crises, financial regulation has created a number of tools for supervisors to make sure financial institutions manage their financial health in a prudent way. These “prudential requirements” include minimum capital requirements as well as requirements in terms of governance and risk management..

The “quantitative approach”: more risks lurking under deceptive economic models

Faced with a new risk (like climate risk), supervisors’ first reaction is to quantify this risk. This approach allows for a direct input of the new data into the existing risk management framework, including supervisory stress-testsUnder the “stress test” exercises, financial supervisors test the balance sheet of big banks and other institutions against severe but plausible hypothetical scenarios (such as economic downturns). The results show if institutions will have sufficient capital and liquidity to withstand the hypothetical shocks. If deemed insufficient, supervisors can then assign actions such as capital increase or restrictions on dividends and share buybacks.. The financial supervision community is already working hard on attempts to quantify climate risk, notably under the umbrella of the Network for Greening the Financial SystemThe Network for Greening the Financial System is a global network of central banks and financial supervisors that aims to accelerate the scaling up of green finance and develop recommendations for the role of central banks when it comes to climate change. (NGFS), which has started to develop “climate scenarios”. And it could work … if only we could reliably quantify climate risk, but we are far from it.

It turns out that the financial system’s real exposure to climate risk is still largely unknown due to climate scenarios understating the effects of climate change by a very large margin. This is because climate scenarios are based on economic models which are unadapted to reflect the phenomenon of climate change and are full of arbitrary assumptions. These models are very limited in their capacity to capture the economic impacts of climate change. At odds with climate science, they fail to account for tipping points— these thresholds that, when crossed, trigger large and irreversible climate changes—, rising sea levels, extreme weather events and disruptions that will emerge from the materialisation of societal risk, such as conflict and mass migration. These shortcomings are recognised by the central banks and financial practitioners themselves.

The financial impact of climate change being seriously understated in climate scenarios, it would be an extremely risky exercise“Stress tests, the “go to” tool for supervisors, use the same climate scenarios whose shortcomings have been discussed before, which means that they do not constitute a precautionary approach for climate risk. Quite the opposite, they contribute to a false sense of security. There are ways to improve them but until they can reliably estimate climate risk, they cannot replace a precautionary approach. Read more on how to improve climate scenarios here to base any prudential intervention on them. Optimistic scenarios, which underestimate the impact of climate change, do not incentivise policymakers and financial institutions to act decisively and in a timely way. In these models, the cost of climate action is de facto much bigger than the cost of inaction. As supervisors can’t rely on quantitative scenarios, they should use qualitative scenarios

But even then, and until the economic impact of climate change is realistically assessed, the financial system is not only driving blind, it is driving without airbags. There is no safety net and big banks are clearly not sufficiently capitalised to survive catastrophic climate change events. Economic authorities and financial supervisors can’t afford to wait until reliable data comes in to justify action: it will be far too late (and may never even come). They must act now as any further delays increase the build-up of risk and the likelihood of a disorderly transition. And the only safe way forward is a precautionary approach to climate risk.

The “qualitative approach”: the only way to integrate unquantifiable risk

Financial supervisors have long deployed tools to mitigate uncharted financial risks, and reduce the likelihood of individual institutions failing and destabilising the wider financial system. They regularly require banks and insurers to raise additionalA lack of bank capital was a major cause of the financial crisis, because under capitalised banks could not absorb losses and had to be bailed out. Since then, regulators have lifted the minimum levels of capital required by a modest amount from a very low base. equity so as to be able to absorb unexpected losses related to the risks they take. This increases institutions’ protection against specific, hard-to-quantify risks. For example, in 2024, EU co-legislators increased capital charges for banks’ investments in crypto-assets to both safeguard against loss of value of speculative crypto-assets and protect financial stability.

Since the 2008 financial crisis and the fall of Lehman Brothers, supervisors have also recognised that treating the financial system as merely the sum of its parts overlooks the system’s historical tendency to swing from boom to bust. The financial markets’ amplification effects resulting from interconnectedness, herd behaviours and spillover effects have proven to be very dangerous for the economy. Nowadays, the systemic dimension of financial stability is considered and supervisors have created tools to protect society against system-wide risks. “Macroprudential buffers” for instance, help shield the financial system from a bank’s risky exposures. They increase banks’ loss absorbing cushions and prevent the build-upSpecifically, systemic risk buffers are aimed at preventing a build up of risk where actions (risk taking decisions) of individual financial institutions contribute disproportionately to the growing systemic risk. of systemic risk in the system.

Climate macroprudential buffers: the path to an orderly transition

All of these tools are already available and can be adapted to climate risk. In the context of mounting climate chaos, financial regulators already have several ways to manage the structural underestimation of climate risks described above.

Finance Watch argues the most efficient way available to address the risk in a timely manner is to implement climate macroprudential buffers: the organisation has proposed one such tool for banks, the logic of which could be extended to insurers. The proposal is that banks should have an extra capital cushionBank capital protects citizens from banking crises. A lack of bank capital was a major cause of the 2008 financial crisis, because under capitalised banks could not absorb losses and had to be bailed out. Since then, regulators have lifted the minimum levels of capital required by a modest amount from a very low base. Read Finance Watch explainer on bank capital for each euro of exposure to fossil fuel assets that is in excess of a threshold required for a safe transition.

Illustration: The “loan-to-value” threshold (an otherwise classic prudential tool) proposed by Finance Watch would be set in proportion to the amount of fossil fuels to which a bank is exposed that can be safely exploited within the carbon budget for a given temperature increase.

Such a tool fits squarely under supervisors’ mandates and practices, is easy to implement, and can be introduced immediately. This alone would:

1. Reduce the build-up of systemic risk through fossil finance,
2. Increase banks’ loss absorption capacity and reduce banks’ exposure to climate risk,
3. Contribute to a safe transition where financial markets start pricing in the financial risk associated with climate change in an orderly way which is a prerequisite to reducing the bill for the physical impacts of climate change and their underinsurance.

Bank federations are lobbying against this proposal, claiming that an increase in capital requirements will reduce lending to the economy and impact economic growth, but this argument doesn’t add up. As reasserted by the Basel Committee on Banking Supervision, banks with higher capital levels lend more, not less.

This proposal would contribute to aligning financial regulation with climate objectives, help prevent the next financial crisis and protect EU taxpayers. Finance Watch is already advocating for this: the legislative window is open with Europe’s review of its macroprudential framework ongoing. But a wider mobilisation is needed to move the lines! You can contribute in different ways:

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The rules of finance are not set in stone, they are decided by people. It is up to civil society to convince decision makers to change them.

Pablo Grandjean, Finance Watch