Wildfires and Floods - a climate Minsky moment triggered by mispriced assets
Amidst unprecedented climate events, a "Climate Minsky Moment" looms on the horizon.
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.
Corporate Sustainability Due Diligence Directive Progresses but Misses the Opportunities in Financial Undertakings
The EU Corporate Sustainability Due Diligence Directive proposes to enforce human rights and environmental due diligence procedures for corporations, aiming to improve their impact on society and the environment. However, the exceptions proposed for financial undertakings overlook a significant opportunity to achieve corporate compliance outside the realm of public and judicial enforcement.
In February 2022, the European Commission (EC) released a draft of the proposed Corporate Sustainability Due Diligence Directive (CSDDD), also known as the Mandatory Human Rights and Environmental Due Diligence Directive. This directive aims to enforce human rights and environmental due diligence procedures for corporations, covering their global operations, including supply chains, to identify and mitigate (or eliminate) the impacts on human rights and the environment. The proposal is expected to apply to approximately 13,000 EU companies (about 1% of all EU companies) and 4,000 non-EU companies. It was largely influenced by a 2020 study by the British Institute of International and Comparative Law, highlighting the inadequacies of voluntary due diligence initiatives.
Despite its intentions, the draft of the CSDDD appeared to be a diluted version of the EC’s initial promises. Understandably, it has been facing significant criticism from practitioners, activists, NGOs, and affected stakeholders who expressed concerns about its limited application to companies and value chains, inadequate mechanisms for victims seeking redress, and other deficiencies in effectively addressing human rights impacts caused by businesses.
| February 2022: EC Proposal for the Directive | |
| Scope | – Applies to very large EU companies with >500 employees and turnover >€150 million – After a two-year transposition period, expands to large companies (>250 employees, turnover >€40 million) in high-impact sectors – Also includes certain non-EU companies in the EU’s internal market (turnover >€150 million for large companies, >€40 million for high-impact sectors)
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| Human Rights and Environmental Standards | – Due diligence covers all adverse human rights and environmental impacts under international human rights and environmental conventions – Compliant with UN’s guiding principles on business and human rights, OECD guidelines for multinational enterprises, and OECD due diligence guidance for responsible business conduct |
| Climate Change Obligation | – Requires certain large companies (EU and non-EU, excluding high-impact sectors) to adopt a plan for a sustainable economy – The plan should address climate change risks and impacts, and include emissions reduction objectives – Remuneration policy should consider fulfillment of these obligations if variable remuneration linked to directors’ contribution to sustainability and long-term interests |
| For Financial Institutions | – Financial undertakings required to conduct due diligence before providing credit, loan, or other financial services to large corporations |
| Directors’ Duty of Care | – Directors of EU companies responsible for overseeing due diligence actions and policies – Directors should consider input from stakeholders and civil society organizations – Member States to amend laws to include consequences of directors’ decisions on human rights, climate change, and environmental issues |
February 2022: EC Proposal for the Directive
Scope
- Applies to very large EU companies with >500 employees and turnover >€150 million
- After a two-year transposition period, expands to large companies (>250 employees, turnover >€40 million) in high-impact sectors
- Also includes certain non-EU companies in the EU’s internal market (turnover >€150 million for large companies, >€40 million for high-impact sectors)
Human Rights and Environmental Standards
- Due diligence covers all adverse human rights and environmental impacts under international human rights and environmental conventions
- Compliant with UN’s guiding principles on business and human rights, OECD guidelines for multinational enterprises, and OECD due diligence guidance for responsible business conduct
Climate Change Obligation
- Requires certain large companies (EU and non-EU, excluding high-impact sectors) to adopt a plan for a sustainable economy
- The plan should address climate change risks and impacts, and include emissions reduction objectives
- Remuneration policy should consider fulfillment of these obligations if variable remuneration linked to directors’ contribution to sustainability and long-term interests
For Financial Institutions
- Financial undertakings required to conduct due diligence before providing credit, loan, or other financial services to large corporations
Directors’ Duty of Care
- Directors should consider input from stakeholders and civil society organizations
- Member States to amend laws to include consequences of directors’ decisions on human rights, climate change, and environmental issues
Since proposed, the CSDDD underwent various stages of discussion and refinement. The European Council’s general approach, proposed in December 2022, suggested raising the directive’s thresholds to limit its scope, while MEPs are considering expanding its coverage to include more companies.
Notably, the European Council disagreed with the Commission’s proposal to include financial undertakings in the directive’s scope and recommended it as a discretionary matter for Member States to decide. On the other hand, MEPs supported the inclusion of financial undertakings and suggested encouraging institutional investors and asset managers to adopt the due diligence procedures.
The European Council has also rejected the provisions related to making due diligence a part of directors’ fiduciary duty of care and linking variable directors’ remuneration to sustainability performance. Instead, they suggest integrating due diligence processes into risk management systems and company policies.
The CSDDD is now expected to undergo trilogue negotiations later in 2023, with the aim of adopting the directive by 2024. However, the rules will not be enforceable before 2025 at the earliest.
| Proposed directive amendments according to Parliament JURI Committee Report (April 2023) | Proposed directive amendments according to Council general approach (December 2022) | |
| Scope | – Lower employee and turnover thresholds: – EU Companies: ≥ 250 employees and turnover ≥ €40 million or ultimate parent of a group with ≥ 500 employees and ≥ €150 million net worldwide turnover – Non-EU Companies: ≥ €150 million turnover with at least €40 million generated in the EU, or ultimate parent of a group with ≥ 500 employees and group turnover as defined above – Abandon the concept of high-impact sectors | – Phase-in approach for application of the directive- First three years: Applies to very large EU companies (>1,000 employees, €300 million net worldwide turnover) and non-EU companies with €300 million net turnover generated in the EU – Four years: Applies to EU and non-EU companies in group 1 – Five years: Applies to EU and non-EU companies in group 2 – Group 1 and group 2 companies subject to CSDD if Commission thresholds met for 2 consecutive years |
| Definitions | – Adverse human rights and environmental impacts clarified with reference to international conventions and instruments – Broader definition of value chain, including additional activities like sale, distribution, transport, storage, and waste management – Expanded scope of affected stakeholders, including workers’ representatives, trade unions, subsidiaries, entire value chains, and vulnerable stakeholders | – Abandons ‘established business relationship’ concept and uses only ‘business partner’ definition – Replaces ‘value chain’ with ‘chain of activities’
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| Single market clause | – Member States required to coordinate efforts for full harmonization during transposition to prevent fragmentation | |
| Regulated financial undertakings | – Regulated financial undertakings remain within scope – Institutional investors and asset managers encouraged to influence investee companies on addressing adverse impacts | – Member States decide on applying the directive to regulated financial undertakings |
| Due diligence | – Risk-based approach for due diligence policies – Proportionate and commensurate policies based on potential adverse impacts, specific circumstances, and risk factors – Identification of individual higher risk business relationships – Companies asked to take appropriate measures and increase leverage with responsible parties to prevent or mitigate potential adverse impacts – Concepts of prioritization and remediation added to due diligence actions | – Strengthens the risk-based approach
|
| Directors’ duty of care | – Deletes the two articles dedicated to directors’ duty of care | |
| Climate change | – Companies obliged to develop and implement a transition plan in line with CSRD reporting requirements – Directors’ variable remuneration linked to the company’s transition plan for companies with > 1,000 employees | – Aligns CSDD text with CSRD amendments – Deletes provision linking climate change obligation to variable part of directors’ remuneration
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| Sanctions | – Member States to define rules on sanctions for infringements – Pecuniary sanctions with a minimum of 5% of net worldwide turnover in the year preceding the fining decision | |
| Civil liability | – Access to justice and effective compensation for victims – Member States required to establish rules on civil liability with a limitation period of at least 10 years – Mandated organizations can bring actions on behalf of victims | – Company not liable if damage caused solely by business partners in its chain of activities – Expressly mentions right to full compensation for victims without over-compensation
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Proposed directive amendments according to Parliament JURI Committee Report (April 2023)
Proposed directive amendments according to Council general approach (December 2022)
Scope
- Lower employee and turnover thresholds:
- EU Companies: ≥ 250 employees and turnover ≥ €40 million or ultimate parent of a group with ≥ 500 employees and≥ €150 million net worldwide turnover
- Non-EU Companies: ≥ €150 million turnover with at least €40 million generated in the EU, or ultimate parent of a group with ≥ 500 employees and group turnover as defined above
- Abandon the concept of high-impact sectors
- Phase-in approach for application of the directive- First three years: Applies to very large EU companies (>1,000 employees, €300 million net worldwide turnover) and non-EU companies with €300 million net turnover
generated in the EU - Four years: Applies to EU and non-EU companies in group 1
- Five years: Applies to EU and non-EU companies in group 2
- Group 1 and group 2 companies subject to CSDD if Commission thresholds met for 2 consecutive years
Definitions
- Adverse human rights and environmental impacts clarified with reference to international conventions and instruments
- Broader definition of value chain, including additional activities like sale, distribution, transport, storage, and waste management
- Expanded scope of affected stakeholders, including workers’ representatives, trade unions, subsidiaries, entire value chains, and vulnerable stakeholders
- Abandons ‘established business relationship’ concept and uses only ‘business partner’ definition
- Replaces ‘value chain’ with ‘chain of activities’
Single market clause
- Member States required to coordinate efforts for full harmonization during transposition to prevent fragmentation
Regulated financial undertakings
- Regulated financial undertakings remain within scope
- Institutional investors and asset managers encouraged to influence investee companies on addressing adverse impacts
- Member States decide on applying the directive to regulated financial undertakings
Due diligence
- Risk-based approach for due diligence policies
- Proportionate and commensurate policies based on potential adverse impacts, specific circumstances, and risk factors
- Identification of individual higher risk business relationships
- Companies asked to take appropriate measures and increase leverage with responsible parties to prevent or mitigate potential adverse impacts
- Concepts of prioritization and remediation added to due diligence actions
- Strengthens the risk-based approach
Directors’ duty of care
- Deletes the two articles dedicated to directors’ duty of care
Climate change
- Companies obliged to develop and implement a transition plan in line with CSRD reporting requirements
- Directors’ variable remuneration linked to the company’s transition plan for companies with > 1,000 employees
- Aligns CSDD text with CSRD amendments
- Deletes provision linking climate change obligation to variable part of directors’ remuneration
Sanctions
- Member States to define rules on sanctions for infringements
- Pecuniary sanctions with a minimum of 5% of net worldwide turnover in the year preceding the fining decision
Civil liability
- Access to justice and effective compensation for victims
- Member States required to establish rules on civil liability with a limitation period of at least 10 years
- Mandated organizations can bring actions on behalf of victims
- Company not liable if damage caused solely by business partners in its chain of activities
- Expressly mentions right to full compensation for victims without over-compensation
The Case for Finance
Regarding the proposed directive, specific exemptions have been granted to financial undertakings by restricting their monitoring responsibilities. Their due diligence requirements apply as a one-off process before the offering of credit, loans, or other financial services, and only when they are offered to large corporations.
The caution around disrupting corporate access to the financial sector is relatively understandable. However, by limiting the due diligence exercise for financial undertakings, the directive overlooks a significant opportunity to achieve corporate compliance outside the realm of public and judicial enforcement.
With finance understood as an ‘enabler’ of business operations and growth, financial undertakings are well-positioned to influence corporate governance practices. There are leverage points identified within the financial system, including project finance screening, loan terms, and public listings, where small shifts across them can create effective and positive systemic change across entire value chains.
Project finance screening stage: If financiers deliberately set corporate social responsibility preferences during the project finance screening stage, dependent recipients of funds would be compelled to amend their business practices to ensure unhindered access to finance.
Loan term: During the loans term, loan covenants- as legally binding contractual terms- are capable of steering borrowers away from HR adverse activities more effectively than shareholder activism, where divergent positions and interests can hamper efforts.
Public listing: The finance sector can leverage corporate transitions into responsible business practices during the company’s private-to-public transition by enhancing corporate responsibility listing requirements on stock exchanges. This is also significant when considering that listing failures have traditionally created reputational costs to businesses.
By controlling financing options and subjecting businesses to increased market scrutiny regarding corporate sustainability performance, financial undertakings can impact corporate competitiveness, internalize human rights and environmental violation costs, and improve informational symmetry across value chains.
In pragmatic terms, financial undertakings have a unique advantage in leveraging their existing due diligence processes, project screenings, and risk management solutions, given their proximity to companies’ investments, activities, and project designs compared to any other sector. Additionally, with increasing corporate social responsibility and environmental litigation risks, there are significant commercial incentives for financial undertakings to monitor the human rights and environmental risk management of corporate fund recipients. With such cost efficiencies and commercial incentives, a limited application to the financial sector seems rather difficult to justify.
As the directive navigates the currents of negotiation, there is scope and opportunity for the binding legislation to precisely capture and reflect the pivotal role of financial undertakings in propelling corporate responsibility forward- and it should not be overlooked.
