Inventing the big hedge

Insurance and risk services must be bold and lead innovation as the world grapples with climate risk, says Peter Kingsley
 

Regulators, banks, insurers, corporations and asset managers share a problem: how to manage an orderly ‘transition’ to a sustainable world while maintaining financial stability.

In the crisis created by COVID-19, the two are more than ever in conflict. Yet the climate is changing fast, and action is more urgent than ever. There are multiple sources of volatility. Culture, contrary to conventional wisdom, can change in months, as futures are reimagined and new narratives emerge. Financial markets are shaped by narrative, sentiment and emotion as much as rational choice.

Even when faced with long-term existential risk, politics is characterised by prevarication – yet this may turn to panic, creating unintended consequences. COVID-19 has shown that government leaders, at least in some parts of the world, cannot be relied upon to protect the long-term public interest. Governments, faced with mounting long-term debt and even solvency crises, may not act as underwriters of last resort against climate change risks to the public, or as partners with the insurance industry. The orderly, policy-led pathway to sustainability may turn out to be a pipe dream.

One of the primary threats to stability is a scenario in which it becomes clear that action to avoid the extremes of runaway earth systems will ultimately fail, irrespective of attempts to reduce emissions – the ‘too little, too late’ scenario. There may be worse to come from revised estimates of ‘physical’ climate risk. In June 2020, as early output from the most recent climate models emerged, concerns grew that ‘climate sensitivity’ assumptions may underestimate the impact of emissions on long-term global temperatures. Against this background, the insurance and broader risk management industries have a decisive, central role – not only in protecting people and assets, but also in inventing the big hedge.

Unhedged and fragile

The world’s financial system is not hedged against climate extremes, and is fragile and vulnerable. Long-ignored structural weaknesses range from ‘zombie companies’ and public sector, private sector and corporate debt, to the challenges facing pension funds and insurers in matching long-term liabilities and investment returns.

There are fears that growing political risks may deepen the problems. ‘Social unrest’ may, in the extreme, escalate into civil wars if health and economic inequalities are compounded by climate change. Meanwhile, trade wars, restrictions on technology and intellectual property, ‘deglobalisation’ and shockwaves from the pandemic may create both supply and demand shocks.

We could see the emergence of a perfect storm: runaway climate change, prolonged economic depression, mass unemployment, political panic measures, radical systemic innovation and culture shocks.

Resistance and denial

Climate change is a force multiplier in a fragile world, yet there is widespread resistance to rapid structural change. Despite the surge in activity surrounding environmental, social and governance factors, concrete progress towards meeting the UN’s Sustainable Development Goals is slow. Bank of America chief executive Brian Moynihan said in June that only a handful of the Fortune Global 500 have committed to carbon neutrality, despite the argument that they will be “better prepared for future risks and for disclosing non-financial metrics”.

There is evidence that stewardship, characterised above all by long-term thinking and radical innovation, will take time to gain momentum. One explanation for this is that companies may be reluctant to reveal the full scale of emissions or potential stranded assets for fear of losing investor support. The hedge,deliberate or not, is to maintain business as usual for as long as possible. Unprecedented scrutiny and transparency will make this a short-term strategy, at best.

The underlying problem is that some sectors cannot reinvent quickly enough. Take aviation: regardless of the pandemic’s impact, ‘green’ aircraft will not emerge for a decade or more. Energy companies and oil-dependent nations face similar challenges: they cannot deliver ‘green energy’ overnight. Total is investing in biofuels, Shell in electric power; BP has committed to zero-carbon operations by 2050. However, none of these strategies will cut emissions in the short timescales demanded by public and investor activists, or meet the challenge to hedge against worst-case climate scenarios.

“The modelling and scenario development tools needed to make targeted judgments will improve decision-making”

Culture shocks

The financial system is particularly vulnerable to short-term climate-related shocks that emerge well ahead of the events themselves. Investors in real estate and infrastructure will withdraw support from ‘brown’ industries and cities decades before they reach crisis point. Markets, driven by emotion, stories and fear, act in anticipation of events. Interpreting how investors imagine the future is as important as mapping the complexities of coastal resilience or relying on data-rich financial model projections that may create a spurious sense of accuracy.

Much of the pressure will come from regulators. Take the framework set out for banking and insurance by the Bank of England’s Prudential Regulation Authority (PRA) in the UK. As recently as March 2019, the narrative was that the “catastrophic impacts of climate change will be felt beyond the traditional horizons of most banks, investors and financial policymakers, imposing costs on future generations that the current one has no direct incentives to fix”. The PRA, the related Financial Regulatory Authority and the Task Force on Climate Related Disclosures frameworks require insurers, banks and corporations to use scenarios to evaluate climate risks until 2050, and to develop strategic responses. Few are equipped to meet these requirements.

Paradoxically, limiting the scenarios to climate risk may encourage reductionist thinking and fail to capture the scale of potential inter-systemic failures. Two rarely recognised but real threats to financial stability stand out. The first is a collective failure of the imagination – the lesson few learned from the 2008 crisis. The second is the inability of government leaders to act against worst-case scenarios when faced by uncertainties surrounding catastrophic risks, illustrated by inaction on COVID-19 in the US, UK and Brazil.

Pre-empting risk

There is, however, good news. The surge in information about regions and cities at risk from flooding and sea-level rise will create better models. Transparency will be decisive. Intelligence techniques are improving.

The upshot is that the modelling and scenario development tools needed to make targeted judgments about everything from underwriting to asset management and supplier networks will improve decision-making.

In parallel, blueprints are emerging. The EU’s Green Deal is the cornerstone of COVID-19 recovery plans. 
The International Energy Authority’s Special Report on Sustainable Recovery (bit.ly/2BroaQL) focuses on short-term policy action and investment amounting to US$1trn each year between 2020-23, aimed at boosting economic growth, saving or creating about nine million jobs a year, reducing greenhouse gas emissions and cutting air pollution.

The question is: how can insurers contribute to the invention of the big hedge, both in their own interests and in broader environmental and social terms? What options will work in all scenarios?

The first option is to support large-scale government borrowing and investment in sustainable infrastructure in places that can withstand extreme climate scenarios.

The second is to withdraw insurance cover and cut investment in fossil fuels and polluting industries, following AXA’s example in 2017.

The third option is for insurers to lead the development of what Mark Carney calls “high-quality disclosure”, insisting that their clients meet rigorous, long-term risk management standards.

The fourth option is to reinvent understanding of systemic risk and deliver early warning systems.

More generally, the industry can reinvent itself in the public mind by contributing to the pre-emption of catastrophic systemic risk, rather than simply underwriting security.

Developing novel insurance products and services is an opportunity to lead innovation, giving inventors confidence to take risks. It is time that insurance is seen as a vital source of innovation and proactive hedging strategies, as well as risk management.
 

Peter Kingsley is chairman of The Oracle Partnership

Image credit | iStock