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The Actuary The magazine of the Institute & Faculty of Actuaries
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Climate change: Stormy weather

At Copenhagen last year, the president of Nauru stood and gave a moving speech scolding countries for not acting on climate change. For them and other island states, it is not about warming but the eradication of their islands and displacement of their people. It is so great a risk that the Maldives are creating a sovereign wealth fund with the sole purpose of buying land to relocate to should the worst eventuality occur. It is more than just the small island states that are in danger from climate change, though. Rising temperatures, sea levels and changes to precipitation patterns among other things will affect almost all countries.

It has often been pointed out that hurricane frequency and severity is increasing; that health will be affected as vectors such as mosquitoes spread; and that property values can change with increased risks of flooding. But actuaries are also well placed to look at more holistic trends in relation to climate risk — for instance, will a country be able to honour its debt obligations as exposure to climate change affects it?

Throughout Europe, over the last few weeks we have seen huge swings in the yields on debt and prices of insuring these debts as weaker economies are hit by trouble in the Eurozone. These troubles are purely financial and have very little to do with international climate politics. But should there be no agreement on climate change, and should we reach a tipping point from which it appears climate change may be irreversible, then debt markets will be forced to focus on a nation’s climate exposure as a result of being forced into spending money on climate change mitigation and adaptation, much of which will be financed via debt. Linking these two concepts together — debt and climate change — at an early stage will benefit investors and will also prompt governments to focus on their climate strategies. An holistic view of the concepts is vitally important, as the potential debt consequences to nations as a result of climate change are too significant to simply dismiss.

For instance, the possible impact on agriculture as a result of climate change serves as an illustration of the potential resulting debt consequences to a nation due to climate change. Failing crops may lead to starvation and malnourishment among a nation’s citizens, while simultaneously harming exports of agriculture and thereby also harming the economies of export destinations. Egypt’s economy, for example, is made up by 18% of agricultural products, mainly cotton, of which it is the world’s largest exporter. If crops were reduced due to climate change, this would lessen Egypt’s gross national income but also have huge effects on the US economy as the largest importer of cotton and cotton goods.

The loss of export-related revenue would likely launch a new cycle of debt issuances to make up the shortfall, compounding existing debt problems. Similarly, France is the sixth largest agricultural exporter in the world, primarily through its wine and cheese industry — these industries could be significantly affected through the impacts of climate change.

The agricultural economy can be easily defined and, to some extent, changes in climate can have predictable outcomes on crop yields. These risks can be measured and priced into insuring debt. Other aspects of how economic production could be derailed by climate change may be harder to quantify. Infrastructure may be damaged, the workforce may be depleted and it may also lead to political instability. Credit ratings agencies play a role in influencing a market’s perceptions of risk; as such, they have a responsibility to incorporate climate change indicators into the analyses. Integrating these climate challenges will be a daunting task, but is necessary for the correct identification of risk.

Like the Carbon Disclosure Project for listed companies, countries should also be required to disclose their susceptibility to events related to climate change. Most governments around the world are already aware of the changes likely to affect them. With this knowledge, and in light of the Stern report, it would be prudent to make investments now rather than at a greater cost later. Issuing debt today, with virtually no climate-identified risk built in, will be much cheaper than issuing debt in decades’ time when climate change is a key risk component and the cost has risen sharply. Sustainable investments can be made across all markets and not just listed equities. One inadvertent mechanism that this might create is to better protect the financial system from crashes in the future; by increasing the cost of insuring debt, bond traders will look more closely at the risks involved.

The issues are especially pertinent to developing countries, which will be hit the hardest. Many of these countries already have huge debt repayments, but they are also likely to be hit the hardest and earlier than others. Indeed, one outcome of implementing climate change into debt markets could be that rigorous analysis of the climate challenge may conclude that some of these countries are not creditworthy, resulting in hugely reduced access to debt. It would then be the role of more climate-resilient nations to offer bilateral loans and raise debt on their behalf, or else increase aid packages.

At Copenhagen, fast-start funding was pledged rising to $100bn per year by 2020. Unfortunately, there is little consensus on where this will come from and many developed nations have yet to follow through with these commitments. The longer that this is delayed, the more likely it is that these countries will require new debt and will also delay their climate change adaptation investments, thereby harming their ability to repay this debt.

A full and holistic approach to analysing the risks of climate change is now required. There are initiatives to introduce climate reporting and sustainable investing into certain markets. However, it is needed across the board of investment products, but is especially relevant to the implications of climate change on sovereign debt. The actuarial profession has long been driving analysis of climate change and should continue to innovate in its response to identifying climate risk.

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Michael Sippitt is managing partner of Clarkslegal LLP