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Schroders : Investors are underestimating physical risks of climate change

Schroders : Investors are underestimating physical risks of climate change

More severe and frequent physical risks are expected to hit sooner than expected. It appears unlikely that the global system will limit global warming to 1.5 °C.

It is increasingly clear that the climate crisis is not only a looming threat but a rapidly unfolding reality. Climate scientists have long warned that we must limit global warming to 1.5 °C to avoid triggering climate tipping points and stave off the worst impacts of climate change. Yet, the data from 2023 paints a chilling picture: it was the warmest year on record, and by a considerable margin.

The urgency to reduce emissions by around 43% by 2030 to limit global warming to 1.5 °C is becoming increasingly obvious, but are we, as a global community, on track to meet this goal?

Limiting global warming to 1.5 °C is not just a goal for environmental sustainability but a crucial factor for maintaining stability in financial markets, how it's appearing increasingly likely that this threshold will be breached within this decade and why more severe and frequent physical risks are expected to hit sooner than anticipated.

It is important to note the growing disconnect between climate science and climate-scenario modelling undertaken by financial firms. This chasm is leading to a severe underestimation of the risks posed by climate change, a miscalculation that could have significant implications for global financial markets. The intersection of climate science and financial analysis has never been more relevant, and understanding these risks is not just important, it’s essential for the resilience and sustainability of global financial markets.

What physical risks are we experiencing which might impact investors?

  • Billion-dollar climate disasters on the rise
  • The insurance sector is coming under pressure from rising natural catastropes
  • Declining food production.
  • More severe droughts are disrupting crucial trade routes

What are the implications for investors?

Elevated volatility: It is more likely than not that financial markets will experience elevated volatility sooner than expected. This can materialise due to:

  • A disorderly transition: delayed action on climate change means that the global system needs transformational change in order to reduce emissions by 43% by 2030 (Stoddard). The scale and pace of the transition required to limit warming to 1.5 °C will be disruptive, costly and messy (UNFCCC).
  • More severe and frequent physical risks, which precipitate abrupt policy change: given the slow progress in our decarbonisation journey, accelerating pace of climate change, and inadequate carbon budgets to limit warming to 1.5 °C – there is a higher probability that the global system (and its financial institutions) will experience higher physical risks sooner. According to the Intergovernmental Panel on Climate Change, or IPCC’s sixth assessment report, physical risks are more severe than anticipated at current levels of warming.

Preparing for a hotter world: adaptation becomes as important as mitigation.

Banks are taking advantage of new revenue streams from the green transition.

Euro area banks are pricing climate risk in their lending policies.

Why is limiting warming to 1.5°C our climate target?

The risk of triggering climate tipping points is significantly higher if the earth warms to a long-term temperature average of 1.5°C compared to pre-industrial levels. Climate tipping points are critical planetary thresholds that, once crossed, create self-reinforcing feedback loops which are irreversible, and which ‘could prevent stabilisation of climate at intermediate temperature rises and cause continued warming even as human emissions are reduced’ (Steffen, Rockstrom; 2018). In other words, the earth will move from self-regulating to self-heating, and human endeavours to limit temperature increases beyond this point might be limited.

Given the interdependence between different climate systems, the crossing of a tipping point in one climate system can catalyse feedbacks that increase the likelihood of crossing other climate system tipping points. This leads to a cascading impact that would push the earth’s system into a significantly hotter state (OECD).

Climate scientists have noted growing cascading risks at current average long-term global temperatures of 1.2°C. The West Antarctic and Greenland icesheet is experiencing significant destabilisation. According to the British Antarctic Survey, the disappearing bright white ice sheets reduce the ability of the earth to reflect the sun’s energy back into space (known as the Albedo effect). The more ice sheets melt, the more heat the darker water bodies absorb. These rapidly melting ice sheets are, in turn, slowing down ocean circulation. Also known as the Atlantic Meridional Overturning Circulation (AMOC) or the Gulf Stream – it is a system which circulates water within the Atlantic Ocean, bringing warm water up north and cold water south. AMOC is the weakest it has been in 1600 years, causing declines in food production (OECD) and destabilising the Amazon forest.

Further reading : The heat is on: How investors are underestimating physical risks of climate change.