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Bank of England’s climate quiz is a breakthrough

By asking insurance companies how their business models are exposed to climate change, the Bank of England has made a big advance in the world’s response. Governments may drag their feet, but at last the world’s financial architecture is beginning to realise the reality of global warming.

The Bank of England’s decision to quiz UK insurance companies about the risks of climate change is an important one. It shows that official institutions are beginning to recognise, in their official actions, that climate change is a material risk.

The Bank of England is not just any official body either, but one of the world’s most prestigious central banks and financial regulators – so what it does carries weight.

The move by the Prudential Regulation Authority, part of the Bank, was prompted by an invitation by the UK’s Department for Environment, Food and Rural Affairs, according to the Financial Times, which broke the story this morning.

But Defra would have found the Bank a willing listener. The PRA is chaired by Mark Carney, governor of the Bank – and he has spoken publicly at least twice about the idea that oil reserves should be thought of as stranded assets. That is a radical stance for such a mainstream financial figure to take.

At a discussion at the IMF annual meetings in Washington on October 10, Carney said: “The vast majority of reserves are unburnable” if the world is to avoid catastrophic climate change.

Scientists have calculated that if we are to have even a fighting chance of limiting global warming to 2C, it will not be possible to burn all the world’s known oil reserves. Yet oil companies are still valued by stock and bond investors as if they could dig up and sell all those reserves.

To point out the disconnect between these two facts makes perfectly logical sense. But it is still a breach of financial orthodoxy.

Fortunately, with the help of forward-looking people like Carney, that orthodoxy is beginning to change.

Not priced in

By sending a questionnaire to the insurance companies it oversees, the PRA is saying that climate change could pose risks to their business models and solvency which are not fully priced in by markets now.

The distinction is important. The PRA is asking insurance companies about their exposure to the catastrophic weather events that are likely to become more common as the climate warms.

Such risks are probably largely priced in by the industry already. Insurance companies have been thinking very hard about weather patterns for years, and are fully incentivised to price risks in this area correctly.

Importantly, too, insurance contracts are typically written for one year at a time. This enables insurers to duck out of areas of coverage that become unattractive, or reprice them to reflect altered risks.

But the other aspect of the PRA’s enquiry concern risks from climate change to the investment side of insurance companies’ businesses. Here, risks may not be priced in.

Massive exposure

Most large insurance companies probably own billions of bonds and shares issued by oil companies – and they are just the most obvious part of the economy that stands to lose if the world shifts to a lower carbon development model. In practice, whole swathes of the economy will have to change.

Yet these risks are not reflected in markets now, because the policy changes required to address them have not been made either.

BP, Exxon and the rest are not only still allowed to dig up and sell all their oil – they are encouraged to do so by the whole governmental and economic system. Until that changes, it is perfectly logical for equity and bond investors still to value their securities highly.

Thus, only an extra-financial spur, such as the PRA’s enquiry, will jolt market participants to consider the unpriced risks.

And because investments are much longer term than insurance contracts, it will be much harder for investors to exit.

New front

Governments around the world are still way behind the curve in their response to climate change.

By starting to factor it in, the Bank of England is opening a new front in the battle to put the world economy on a sane path. On this new front, the fighters are not governments – subject to political pressure – but quasi-independent bodies like financial regulators. Good luck to them.

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