Wildfires and Floods - a climate Minsky moment triggered by mispriced assets

In the 1960s and 1970s, the American economist Hyman Minsky developed his “financial instability hypothesis”, which explained financial and economic crises as natural consequences of financial capitalism. Rather than follow mainstream economists in modelling these crises as the result of external shocks, Minsky theorized that (*to borrow a horror movie cliché*) the true threat of financial instability wasn’t lurking outside; instead, it resided within the very walls of the financial system.”

For Minsky, periods of sustained economic growth numb investors to the risks associated with their investments, as positive financial conditions mask losses. This leads to ever more speculative investments being made, as in the 2007-08 subprime mortgage crisis, where a sustained period of calm allowed investors to convince themselves that packages of barely-viable loans were an essentially risk-free investment. The point where this all comes crashing down has been dubbed the “Minsky moment”.

In 2015, former Bank of England governor Mark Carney cautioned the finance industry about the risks of a “climate Minsky moment”. This refers to a rapid breakdown of the financial system that might be initiated by a sudden and sharp correction in asset values as investors realize that these values are unsustainable and misrepresentative of climate change risks.

Such a scenario could prompt the offloading of assets in sectors vulnerable to climate change impacts, such as fossil fuels, insurance, and real estate. This chain reaction of market collapses may subsequently reverberate throughout the broader economy, leading to a recession or, in more extreme cases, a full-fledged financial crisis.

A substantial climate-related catastrophe, like a superstorm or an extreme heatwave, stands as a catalyst to a climate Minsky moment. Equally influential could be a major governmental policy shift, such as the implementation of a carbon tax or the prohibition of new high emission energy plants.

With recent news of aggressive wildfires and floods aggravated by climate change, it is clear that the financial risks of climate change are significant and growing. During this summer, the evacuation of hundreds of thousands of tourists from fire-ravaged islands served as a stark reminder of the perils that climate change poses to the tourism sector.

In the US, analysis of the costs of wildfires and floods to real estate investors highlighted that US flood-exposed residential properties are overvalued by $121B to $237B due to outdated federal flood maps and government-subsidized insurance. In addition, a prominent “Big Short” investor has noted that in 2021, wildfire damages exceeded premiums by sixfold, creating a potential risk of $495B property value drop should insurers address this gap.

Research from economist Steve Keen and Carbon Tracker has found that the financial sector may be dramatically underestimating physical climate risk by assuming that it has a relatively linear relationship with temperature rises, and failing to price in non-linear risks such as a breakdown of the Gulfstream. In addition, a recent FT article argues that businesses and investors have paid less attention to the physical effects of climate change and more to the costs and risks of decarbonising.

The UK Pensions Regulator recently expressed worry that the impacts of climate change in financial modelling “seem relatively benign and appear to be at odds with established science.” The Financial Stability Board warned in November that the scenarios used to assess the financial system’s risks may underestimate climate vulnerability. In addition, a growing number of financial institutions, ranging from BlackRock to the Bank of England, have warned that markets may not be accurately incorporating climate change-related risks into asset prices.

Some scholars have even argued that the undervaluing of corporate climate risk amplifies the adverse consequences of climate change. This stems from the current undervaluation of risk causing a misguided allocation of investment capital, impeding future adaptation efforts, and inadvertently supporting future fossil fuel usage.

Mispricing at the individual asset level

An article titled “Market Myopia’s Climate Bubble” draws upon scholarly insights in corporate governance and market (in)efficiency mechanisms to showcase the prevalence of mispricing at the individual asset level. The study revealed the following causal factors:

• Insufficient availability of fine-grained asset-level data necessary for accurate risk assessment.
• Persistence in using outdated means of assessing risk.
• Discrepancies in incentives leading to climate-specific agency costs.
• Distortion of judgment due to myopic biases, intensified by misinformation about climate change.
• Impediment of pricing due to captured regulators distorting the market.
• Furthermore, the trends in institutional share ownership exacerbate indifference towards the evaluation of firm-specific fundamentals, particularly over long term-horizons.

There is effort from the International Monetary Fund to measure and raise awareness of these risks. Notable is the integration of climate risk analysis into their scenario-based stress tests to assess its effects on bank stability and the broader economy. However, the IMF has acknowledged challenges in this pursuit, including complexities of modeling climate risk and its economic impacts over very long horizon, and major data gaps.

To mitigate and reduce the financial losses caused by climate change, financing investment into climate-resilient infrastructure, such as flood defenses and drought-resistant crops, is encouraged. According to research, spending $50bn a year on flood defences for coastal cities could reduce expected losses of $1tn to some $60bn in 2050. We are also seeing once-skeptical European nations now embracing gene-edited crop varieties engineered to withstand extreme temperatures and drought, with Brussels even proposing the relaxation of restrictions on certain gene-edited crops.

As the lifeblood of the global economy, the financial sector has a responsibility to take these risks seriously as it is essential that it is resilient to the challenges posed by climate change. To avoid the risk of a climate Minsky moment, it is imperative that the finance sector develops better data and metrics for assessing climate risk to help enhance the understanding of risks and develop tools that better quantify and price these risks into asset prices. However, this cannot be achieved unless businesses and investors are more transparent about their exposure to climate risks.