A team of economists recently analyzed 20 years of peer-reviewed research on the social cost of carbon, an estimate of the damage from climate change. They concluded that the average cost, adjusted for improved methods, is substantially higher than even the U.S. government’s most up-to-date figure.
That means greenhouse gas emissions, over time, will take a larger toll than regulators are accounting for. As tools for measuring the links between weather patterns and economic output evolve — and the interactions between weather and the economy magnify the costs in unpredictable ways — the damage estimates have only risen.
It’s the kind of data that one might expect to set off alarm bells across the financial industry, which closely tracks economic developments that might affect portfolios of stocks and loans. But it was hard to detect even a ripple.
In fact, the news from Wall Street lately has mostly been about retreat from climate goals, rather than recommitment. Banks and asset managers are withdrawing from international climate alliances and chafing at their rules. Regional banks are stepping up lending to fossil fuel producers. Sustainable investment funds have sustained crippling outflows, and many have collapsed.
So what explains this apparent disconnect? In some cases, it’s a classic prisoner’s dilemma: If firms collectively shift to cleaner energy, a cooler climate benefits everyone more in the future. But in the short term, each firm has an individual incentive to cash in on fossil fuels, making the transition much harder to achieve.
And when it comes to avoiding climate damage to their own operations, the financial industry is genuinely struggling to comprehend what a warming future will mean.
To understand what’s going on, put yourself in the shoes of a banker or an asset manager.
In 2021, President Joe Biden brought the United States back into the Paris Agreement, and his financial regulators started issuing reports about the risk that climate change posed to the financial system. A global compact of financial institutions made commitments worth $130 trillion to try to bring down emissions, confident that governments would create a regulatory and financial infrastructure to make those investments profitable. And in 2022, the Inflation Reduction Act passed.
Since then, hundreds of billions of dollars have flowed into renewable-energy projects in the United States. But that doesn’t mean they’re a sure bet for people paid to build investment strategies. Clean-energy stocks have been pummeled by high interest rates and supply-chain hiccups, resulting in the cancellation of offshore wind projects. If you bought some of the largest solar-energy exchange-traded funds in early 2023, you would have lost about 20% of your money, while the rest of the stock market soared.
“If we think about what is going to be the best way to tilt your portfolios in the direction to benefit, it’s really difficult to do,” said Derek Schug, the head of portfolio management for Kestra Investment Management. “These will probably be great investments over 20 years, but when we’re judged over one to three years, it’s a little more challenging for us.”
Some firms cater to institutional clients, like public employee pension funds, that want combating climate change to be part of their investment strategy and are willing to take a short-term hit. But they aren’t a majority. And over the past couple of years, many banks and asset managers have shrunk from anything with a climate label for fear of losing business from states that frown on such concerns.
On top of that, the war in Ukraine scrambled the financial case for backing a rapid energy transition. Artificial intelligence and the movement toward greater electrification are adding demand for power, and renewables haven’t kept up. So banks kept lending to oil and gas producers, which have been churning out record profits. Jamie Dimon, the CEO of JPMorgan Chase, said in his annual letter to shareholders that simply halting oil and gas projects would be “naive.”
All of that is about the relative appeal of investments that would slow climate change. What about the risk that climate change poses to the financial industry’s own investments, through more powerful hurricanes, heat waves that knock out power grids, wildfires that wipe out towns?
There is evidence that banks and investors price in some physical risk, but also that much of it still lurks, unheeded.
Over the past year, the Federal Reserve asked the nation’s six largest banks to examine what would happen to their balance sheets if a large hurricane hit the Northeast. A summary last month reported that the institutions found it difficult to assess the impact on loan default rates because of a lack of information on property characteristics, their counterparties and especially insurance coverage.
Parinitha Sastry, an assistant professor of finance at Columbia Business School, studied shaky insurers in states like Florida and found that coverage was often much weaker than it appeared, making mortgage defaults after hurricanes likelier.
“I’m very, very worried about this, because insurance markets are this opaque weak link,” Sastry said. “There are parallels to some of the complex linkages that happened in 2008, where there is a weak and unregulated market that spills over to the banking system.”
Regulators worry that failing to understand those ripple effects could not just put a single bank in trouble but even become a contagion that would undermine the financial system. They have set up systems to monitor potential problems, which some financial reformers have criticized as inadequate.
But while the European Central Bank has made climate risk a consideration in its policy and oversight, the Federal Reserve has resisted taking a more active role, despite indications that extreme weather is feeding inflation and that high interest rates are slowing the transition to clean energy.
“The argument has been, ‘Unless we can convincingly show it’s part of our mandate, Congress should deal with it, it’s none of our business,’” said Johannes Stroebel, a finance professor at New York University’s Stern School of Business.
Ultimately, that view might prove correct. Banks are in the business of risk management, and as tools for climate forecasting and modeling improve, they can stop lending to obviously at-risk businesses and places. But that only creates more problems for the people in those places when credit and business investment dry up.
“You can conclude it’s not a threat to financial stability, and there can still be large economic losses,” Stroebel noted.
While assessing where the risks lie in one’s portfolio remains difficult, a much nearer-term uncertainty looms: the outcome of the U.S. election, which could determine whether further action is taken to address climate concerns or existing efforts are rolled back. An aggressive climate strategy might not fare as well during a second Trump administration, so it may seem wise to wait and see how it shakes out.
“Given the way our system has moved so far, it’s so slow moving that there’s still time to get on the other side of the proverbial fence,” said Nicholas Codola, a senior portfolio manager at Brinker Capital Investments.
John Morton served as a climate counselor to Treasury Secretary Janet Yellen before rejoining the Pollination Group, a climate-focused advisory and investment management firm. He has observed that big companies are hesitating on climate-sensitive investments as November approaches, but says that “two things are misguided and quite dangerous about that hypothesis.”
One: States like California are establishing stricter rules for carbon-related financial disclosures and may step it up further if Republicans win. And two: Europe is phasing in a “carbon border adjustment mechanism,” which will punish polluting companies that want to do business there.
“Our view is, be careful,” Morton said. “You’re going to be disadvantaged in the market if you’re left holding a big bag of carbon 10 years from now.”
But at the moment, even European financial institutions feel pressure from the United States, which — while providing some of the most generous subsidies so far for renewable-energy investment — has not imposed a price on carbon.
The global insurance company Allianz has set out a plan to align its investments in a way that would prevent warming above 1.5 degrees Celsius by the end of the century, if everyone else did the same. But it’s difficult to steer a portfolio to climate-friendly assets while other funds take on polluting companies and reap short-term profits for impatient clients.
“This is the main challenge for an asset manager, to really bring the customer along,” said Markus Zimmer, an Allianz economist. Asset managers don’t have sufficient tools on their own to move money out of polluting investments and into clean ones, if they want to stay in business, he said.
“Of course it helps if the financial industry is somehow ambitious, but you cannot really substitute the lack of actions by policymakers,” Zimmer added. “In the end, it’s very hard to get around.”
According to new research, the benefit is greater when decarbonization occurs faster, because the risks of extreme damage mount as time goes on. But without a uniform set of rules, someone is bound to scoop up the immediate profits, disadvantaging those that don’t — and the longer-term outcome is adverse for all.
“The worst thing is if you commit your business model to 1.5-degree compliance, and 3 degrees are realized,” Zimmer said.
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