2.3.6.1 Earth system destabilisation and financial destabilisation

Research on the significant, non-linear effects of climate damages on the global economy is well established (Diffenbaugh and Burke, 2019; Martinich and Crimmins, 2019; Hsiang et al., 2017; Carleton and Hsiang, 2016; Burke et al., 2015), albeit likely severely underestimating climate damage (Winter and Kiehl 2023; Keen 2021). The impacts of Earth system destabilisation on the financial sector are now receiving increasing attention too, with studies suggesting that climate-related damages will impact the stability of the global Cronafinancial system significantly (Curcio et al., 2023; Kemp et al., 2022; Crona et al., 2021; ECB, 2021; ESRB, 2020; IMF, 2020; FSB, 2020). Escalating climate change, particularly where it leads to breached Earth system tipping points, would progressively, or abruptly, destroy the capital of firms, reduce their profitability, deteriorate their liquidity and reduce the productivity of their workforce, leading to a higher rate of default and harming the financial sector (Dafermos et al., 2018). Such an impact on firms’ bankruptcies would cascade down to banks, accumulating a stock of bad debt and destabilising their own balance sheets, resulting in more frequent banking crises (Lamperti et al., 2019). Globally, consequences of climate change and breached Earth system tipping points are likely to trigger correlated shocks across large regions (Walker et al., 2023).

Breached tipping points are also likely to overwhelm the insurance industry. In 2015, ahead of COP 21 in Paris, the former CEO of AXA declared:

A 2°C world might be insurable, a 4°C world certainly would not be.

Bacani, 2016

At a hearing on climate risks and its potential threat to the federal budget organised by the US Senate Budget Committee in March 2023, representatives from the insurance industry noted that, with climate change escalating, the industry is experiencing a crisis of confidence with respect to its ability to predict loss. Reinsurance companies are withdrawing increasingly from areas exposed to high climate change risks – for example, areas vulnerable to wildfires and floods (Frank, 2023). The multiplication of extreme weather events will certainly impact the value of physical assets (Caldecott et al., 2021). For instance, hurricane damage to properties could rise by as much as 275 per cent by 2050 due to their higher frequency and intensity (Schulten et al., 2019). However, the models used to estimate climate risks have been found to be often inadequate and likely to underestimate the risks (Kedward et al., 2023; Trust et al., 2023; FSB and NGFS, 2022).

Additionally, climate change mitigation, such as shifting to renewable energy production, fossil fuel divestment and/or phase-out, are likely to lead to the stranding of various types of assets, notably related to the fossil fuel industry, which may have wider implications – for example for pension funds, but also for state revenues in fossil fuel-producing nation states (Mercure et al., 2018; Semieniuk et al., 2022; Caldecott et al., 2021). The danger of destabilisation because of stranded fossil fuel assets is particularly big when force majeure (e.g. the breaching of an Earth system tipping point) would require an abrupt and badly managed transition to zero carbon.

Early and stable policy frames can facilitate smooth asset value adjustments as part of fossil-fuel phaseout, but late and abrupt policy frameworks could have adverse systemic consequences. 

Battiston et al., 2017

However, by far the biggest issue with the existing empirical evidence, predictions and models that try to estimate climate damage for the financial sector is that they do not account for Earth system tipping points (Keen et al., 2022; Galaz et al., 2018).