That February, extremely low temperatures almost brought the Texas power grid to a halt, causing blackouts that left millions without power. For utilities, environmental challenges of this magnitude can be devastating. Consider PG&E, California’s largest electric utility. Burdened with $30 billion in liabilities, the company filed for bankruptcy in 2019 after assuming responsibility for around 1,500 fires first major corporate sacrifice of climate change.
Unfortunately, more can be added. Economic losses related to natural catastrophes totaled a staggering US$190 billion in 2020, according to Swiss Re, with insured losses estimated at US$81 billion. The IMF recently warned equity investors that they are underpricing the risks of climate change. There are plenty of reasons for this, from a lack of regulation and difficulties in calculating risk to a surprising lack of awareness of the problem. But the stakes are high – the value of the world’s financial assets at risk has been estimated by The Economist at $4.2 trillion.
Regulators have the power to get the ball rolling. The Paris Agreement formalizes the obligation for investors to integrate climate change planning into their investment strategies. The Bank of England’s Prudential Regulatory Authority (PRA) has set out a list of priorities for banks and insurers to manage long-term climate risk. Their boards, the PRA recommends, must assess “the characteristic elements” of climate-related financial risks and take a long-term view “beyond normal business planning horizons”.
The Task Force on Climate-related Financial Disclosures proposes that financial services firms should adopt climate change risk reporting and ideally include it in financial records. The million dollar question is, of course, whether that would be mandatory. Smaller companies can complain badly and raise concerns about the costs and the bureaucratic burden.
If there’s one industry that needs to step up, it’s the insurance industry. The growing gap between economic and insured losses certainly raises relevant questions about the sector’s catastrophe modeling tools based on long-term climate stability.
These issues are becoming increasingly important when it comes to infrastructure development, a key factor in government initiatives to rebalance the economy. The new US administration and the EU have stressed the need to invest in green infrastructure as part of their stimulus plans.
The problem is that investments in infrastructure, a sector particularly vulnerable to climate change, require long-term insurance products. And yet these cannot be developed unless the risks are well understood, disclosed and priced. Without proper risk assessment, infrastructure insurance premiums remain uncompetitive. And if infrastructure investors don’t price climate risk into their models, their return expectations will be imprecise at best. Think of the insurance premiums it would take to build iconic infrastructure in our time. How many investors today would dare fund construction in New York City without a reliable climate risk assessment and insurance coverage?
One way to solve this conundrum is to develop and use data that can help insurance providers and investors better assess risk. For example, one powerful tool they can use is Earth Observation data such as water cycles and distribution, land use from flooding, and heat mapping. As Harvard Business School academic Rebecca Henderson notes in her influential book Reimagining Capitalism, environmental, social and business (ESG) metrics that capture the costs and benefits of addressing environmental and social issues can reassure investors that they are more green than greedy is a good thing. One reason many investors are hopelessly short-term, Henderson says, is that they don’t have reliable data.
The insurance sector needs to invent a radically different pricing mechanism for these products. When investors are buyers of climate risk and insurance providers are sellers, they both face the same problem: radical uncertainty. Current climate risk pricing models are inadequate at best. One reason is that they are based on equally flawed climate prediction models and often imply that climate change is a long-term phenomenon that is best priced into the future.
For their part, investors such as pension funds are also groping in the dark and are often faced with unsavory binary decisions: to build or not to build? In other words, they buy something without knowing the actual price and have to make assumptions about insurance availability and mid-term affordability while the projects are still being built. To complicate matters further, insurance companies are investors themselves as they happen to be large real estate owners, particularly in Europe.
Both politicians and insurers have recognized the need to develop better pricing models. For this reason, there are a variety of organizations and initiatives working in this direction, including the UN Environment Programme’s Principles for Sustainable Insurance Initiative, the Insurance Development Forum, the Coalition for Climate Resilient Investment and the InsuResilience Global Partnership for Climate and Disaster Risk finance and insurance solutions. As in other areas of green finance, there is an obvious overlap of responsibilities. We need a multilateral, coordinated approach that brings all stakeholders together and encourages the development of solutions to address these challenges.
We cannot avoid natural disasters. But we can put the right price tag on them. One can hope that a marketplace will soon develop where insurance providers and investors can work together and find solutions.
Abhisheik Dhawan is a sustainable finance and partnership expert at the UN Capital Development Fund (UNCDF). making public and private finance work for the poor in the world’s 46 least developed countries making public and private finance work for the poor in the world’s 46 least developed countries. The views expressed by the author are personal.
