Market Disregard for Resilience: Exploring the Rationale Behind Lower Valuations of Reinforced Strength and Adaptability
In the face of escalating climate and nature shocks, financial systems are grappling with the challenge of internalizing physical climate risks. A recent report reveals that climate shocks have erased $525 billion in value across emerging markets, highlighting the urgent need for change.
The upcoming COP30 summit in Brazil offers an opportunity to mainstream resilience in financial reform. Here are four strategies that could help financial systems better price and manage climate risks, promoting more effective capital allocation in a warmer world.
1. **Integration of Climate-Adjusted Models**
Utilizing specialized tools and data analytics platforms can help assess climate-related risks accurately. By integrating climate data into financial models, we can better predict potential impacts on assets and investments. Implementing risk-based pricing strategies that reflect the true level of climate risk encourages investment in resilient infrastructure and projects.
2. **Enhanced Credit Risk Modelling**
Developing credit risk models that explicitly account for physical climate risks is crucial. Incorporating stochastic factors to model climate-related damage and its impact on asset values can help manage climate-induced credit risk. Portfolio models can measure the contribution of physical risks to overall credit risk losses, enabling more effective risk management.
3. **Market-Aligned Responses and Sustainable Finance**
Encouraging the internalization of environmental externalities in bond markets through ESG criteria helps align financial systems with climate resilience goals. Resilience-linked products, such as resilience bonds, can mitigate investment risks while contributing to building climate-resilient infrastructure, supporting long-term sustainability and returns.
4. **Adaptation and Incentives**
Implementing policies and financial instruments that support efficient adaptation to climate change is essential. Shifting from constrained homeownership to rental models can facilitate more efficient adaptation, especially for credit-constrained households. Offering incentives for investments in climate-resilient projects and infrastructure through tax benefits, subsidies, or preferential interest rates can encourage resilience investments.
By adopting these strategies, financial systems can better internalize and price physical climate risks, ensuring more effective capital allocation and resilience in the face of climate change. However, the heart of the problem lies in an asymmetry in how the risks and returns of investment decisions are evaluated, with risk often penalized and returns on resilience ignored.
Global markets continue to invest in assets designed for a cooler, more predictable era, despite escalating climate and nature shocks. Yet, several companies have demonstrated that climate adaptation can enhance performance, stability, and creditworthiness. Investing in resilience can reduce the severity and duration of economic losses. Countries that invest in resilience today are predicted to be the growth leaders of tomorrow.
Credit rating agencies rarely credit countries for resilience investments, punishing exposure but not rewarding preparedness. Investments in resilience remain marginal and underfunded, with over 20 million people displaced due to climate and nature shocks in the past two decades.
The demand for resilience solutions is expected to reach between $500 billion and $1.3 trillion by 2030. Homes built to updated wind-resilient building codes have 50% lower mortgage delinquency rates after hurricanes compared to older homes. Embedding resilience into fiscal frameworks, credit ratings, financial disclosures, and monetary policy could unlock trillions in capital.
For every dollar spent on climate-resilient infrastructure, $87 goes toward infrastructure with no resilience considerations. The time for action is now. By adopting these strategies, we can build a more resilient financial system that can withstand the challenges of a warming world.
- Science and environmental science play a pivotal role in informing the financial sector about the physical climate risks associated with climate-change.
- Integrating climate-adjusted models, enhanced credit risk modeling, market-aligned responses, sustainable finance, and adaptation incentives (as proposed by Guido Schmidt-Traub and the Bridgetown Initiative) can help financial markets better price and manage climate risks, promoting sustainable growth and effective capital allocation in a warmer world.
- Mispriced risks due to an asymmetry in evaluation between risk and returns pose a significant challenge in the internalization of physical climate risks, hindering more resilient growth. Encouraging the credit rating agencies to reward preparedness, rather than punishing exposure, is crucial to unlocking capital for resilience solutions, supporting the future growth leaders of tomorrow.
