The place to look for the earliest signs of stress is in those markets most exposed to climate risk, which are both liquid but lightly regulated, Benjamin Keys, an expert on the financial risks of climate change says.HO/The Canadian Press
John Rapley is a contributing columnist for The Globe and Mail. He is an author and academic whose books include Why Empires Fall and Twilight of the Money Gods.
In 2020, the Bank for International Settlements produced a study that floated the risk of a green swan – a climate event that triggers a market crash. The idea was borrowed from Nassim Nicholas Taleb’s concept of a black swan – a highly improbable, unpredictable event whose impact can be huge.
Mr. Taleb used the metaphor because, until they first encountered black swans in Australia a couple of centuries ago, Europeans assumed all swans were white because the only swans they’d ever seen were white. But that well-documented conclusion didn’t alter the fact of the existence of black swans.
In the book of the same name, which appeared just before the 2008 financial crisis, Mr. Taleb argued that the predictive models used by financial houses to anticipate economic shocks relied on past experience and so failed to anticipate new shocks. That left them wholly unprepared for what was coming.
The BIS paper, which appeared during the pandemic – itself a black swan event whose impact on the world economy was catastrophic – raised the possibility that a climate shock, such as an extreme weather event, could cause asset values to fall, triggering a chain reaction through the financial system.
Much as happened when house prices fell in 2008, a major event could destroy houses and render many more uninsurable, killing their resale value. As banks lost security from collateral, they’d have to liquidate other assets, starting a chain reaction that could become self-reinforcing.
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To date, despite the rising intensity of extreme weather, asset markets haven’t yet repriced in a significant way. But as with a black swan, it would be a huge mistake to assume that because it hasn’t happened, it won’t. The truth is, we’ve never seen anything like the weather we’re experiencing now, so we’re in uncharted territory.
Benjamin Keys, an expert on the financial risks of climate change at the University of Pennsylvania’s Wharton School, says the place to look for the earliest signs of stress is in those markets most exposed to climate risk, which are both liquid but lightly regulated. Insurance and reinsurance lead the way, and we’re seeing significant and sustained inflation in both – 25 per cent in real terms since 2018 in the U.S. Europe has seen similar increases in insurance costs, even as coverage has declined.
We’ve yet to see major price drops in real estate or in the REIT sector. However, Prof. Keys says that doesn’t mean the problem isn’t there. Citing Florida as an example, where storm risk has sharply lowered prices in some vulnerable areas, countervailing trends such as the COVID boom and baby boomers retiring to warmer climes have helped soften such declines.
Moreover, given the relative illiquidity of real estate markets – sellers who aren’t under pressure will often withdraw a property from the market if the money they’re being offered isn’t appealing – such sharp price drops may take a while to materialize.
But when they do, they could prove to be fundamentally different, and worse, than the financial crises of history. Earlier crashes were caused by cyclical bubbles, which, once they burst, eliminated excesses in the economy and put markets back on a sustainable path. Prof. Keys points out that the harm done by climate change is structural, not cyclical: Once climate change begins knocking down asset values, it will only get worse – unless and until we arrest climate change.
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Canadian investors may also need to consider another factor in their long-range planning, and that’s the impact of future climate litigation on asset prices. A recent advisory ruling by the International Court of Justice held that countries can be held liable for their carbon emissions and that those harmed by climate change may be entitled to claim damages. Given Canada’s less-than-stellar record on the climate, the weight of the fossil-fuel industry in the country and the fact that Canadian courts will regard the ICJ ruling as an authoritative statement on international law, investors should take note.
Fraser Thomson, a lawyer with environmental law charity Ecojustice, told me it is reasonable to expect a wave of litigation against fossil-fuel companies, adding that Canadian courts have already shown they’ll follow the science when rendering decisions.
One can envision situations in which homeowners whose investments must be written off owing to climate change, or people whose health has been adversely affected by extreme weather events, could sue fossil-fuel companies for damages. Plaintiffs could be governments, citizens or insurance companies facing losses, and Mr. Thomson reckons the judgments will start to appear within the next decade.
But well before that, as investors anticipate future damage claims, share values will begin to take a hit. Best to prepare now, because the price could rise pretty high.