Climate Tipping Points Demand Risk Management Rethink

Programming Note: The next Thursday newsletter will be published on January 4.

Global Tipping Points (GTPs) refer to critical thresholds within Earth’s systems that, if crossed, could trigger irreversible and abrupt changes with far-reaching consequences for ecosystems, societies, and economies. Think the collapse of coral reefs, the melting of Arctic sea ice, forest dieback, and permafrost thawing. All scary (and increasingly likely) possibilities for the planet, with just-as-scary consequences for the financial sector.

GTPs were thrust into the collective consciousness by the release of The Global Tipping Points report earlier this month, a comprehensive study conducted by the University of Exeter which provides valuable insights into specific Earth system tipping points and their potential impacts on societies and ecosystems. As reported Monday, the report emphasizes the need to rethink our approach to climate adaptation if and when GTPs are breached.

It’s not all doom-and-gloom, though. The report also highlights “positive tipping points” that, if triggered, could accelerate climate mitigation and lower the risk that the nasty kind of tipping points are breached. One example is the mainstreaming of electric vehicles through policy incentives and market competition. This tipping point could be accelerated if major economics banned future sales of internal combustion engine vehicles. 

The report gives policymakers plenty to chew over. But it should spur some deep thinking across the financial sector, too. The growing scientific evidence of GTP dangers compels financial institutions to consider if and how they should factor them into risk management, portfolio development, and investment strategies. 

The Tipping Points Challenge

“If” may be the operative word. Integrating GTP risks into existing workflows may stretch institutions’ capabilities, and require an overhaul of current practices. 

For starters, GTP risks are both systemic and localized. While breaching key planetary boundaries may result in planet-wide shifts in air, water, and land systems, some regions are expected to experience harsher impacts than others. So although all financial institutions should want to prevent GTP breaches to reduce the systemic impacts, those with investments concentrated in less vulnerable regions may be harder to incentivize. In addition, as GPT impact projections evolve, it may become clearer which parts of the world are particularly at risk. This in turn could trigger a “flight to safety”, with institutions pulling investments from these regions before the impacts manifest.

Then there are the time horizons to consider. Once a tipping point is crossed, the affected system moves to a new state, and the resulting impacts are locked in. However, these impacts may unfold over very long periods of time. For example, the Greenland tipping point could lead to the disintegration of the entire ice sheet over several thousand years, resulting in accelerated sea level rise – but not in our lifetimes. 

This characteristic of GTPs is a challenge to traditional risk management. While the opportunity to mitigate GTP risks is in the gift of governments, businesses, and financial institutions today, most of the benefits – loss prevention, higher asset values, and so on – are likely to accrue to future generations. This makes it tough to incentivize risk managers to make GTP mitigation a priority, who understandably want to focus on near-term risks that have the potential to topple their firms tomorrow, rather than a thousand years from now.

Another challenge is identifying and quantifying the knock-on effects of GTP breaches. If certain planetary boundaries are crossed, while the worst physical impacts may not be felt for generations, their slow build up over time could amplify other global risks and cause some to spill over in complicated and financially ruinous ways. For example, creeping desertification in certain regions could undermine agricultural economies, leading to mass bankruptcies. This impact in turn could cascade down to banks, resulting in an accumulation of bad debt which leads to financial crises. 

In addition, GTP breaches may lead to increased incidences where severe acute physical risks – think floods, droughts, and wildfires – happen concurrently at different points on the globe. This could pose an existential threat to insurers, which may be unable to construct diversified underwriting portfolios to spread their risks out. A regime shift in the frequency and severity of acute risks could also lead to a crisis in confidence in the insurance industry’s ability to predict losses, too.

Leveling Up Risk Management

Factoring GTPs into traditional risk management may be a quixotic exercise given these challenges. But that’s exactly why a rethink over risk management is justified. Existing modes of risk identification, mitigation, and avoidance can’t deal with climate change. Nor can prevailing market and economic incentives (remember Mark Carney’s “Minsky Moment” speech?)

Ultimately, new and improved rules, policies, and standards are needed to reshape the regulatory landscape and force financial institutions to integrate GTPs into risk management. Some jurisdictions have already taken baby steps in this direction (the European Union and California especially), but in many others the chances of big, meaningful policy shifts occurring in the near term are limited by political and legal constraints (we’re looking at you, US Securities and Exchange Commission).

Still, imagine these limits did not exist. What would effective GTP risk management look like in the financial sector? Here are some ideas:

Don’t Go It Alone

Some climate leaders in the financial sector may adopt this refactoring of risk management without having to be chivvied along by regulators or policymakers — especially those already up to their eyeballs in unfolding climate physical risks. Others may stick to the old way of doing things, betting that GTP breaches won’t alter the risk landscape over the course of a regular business cycle.

If each financial institution goes their own way on GTP risks, though, the systemic dangers they pose will go unaddressed. As the Global Tipping Points report makes plain, it’ll take collaboration, coordination, and a whole lot of combined effort to prevent GTPs from being triggered. Riding solo is not an option.