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Climate change — The risk, costs and mitigation tools

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Climate Risk and Resilience

December 17, 2020

Climate change is having an immediate effect on the financial markets and industries are taking greater control over mitigating climate-related risks.

In a 2019 report, for the fourth year in a row, a leading survey of diverse global experts identified climate change as the number one emerging risk for the next five to 10 years. According to the survey, the consensus on the matter is strong and growing, with survey respondents identifying climate change as a top-five risk, increasing from 39% only two years ago to 67%, naming it the most important emerging risk last year.1

Climate risk as a critical issue is now clear as record losses demonstrate its financial materiality. In a report released last year surveying the risk and opportunities created by climate change, submissions from the world’s largest corporations, including U.S. companies representing nearly $17 trillion in market capitalization, estimated that they face approximately $1 trillion in costs related to climate change in the decades ahead unless they take proactive steps to prepare for this risk. The survey respondents, ranging from Silicon Valley companies to large European banks, are facing the prospect that climate change may substantially impact their financial fortunes within the next five years. The companies estimated that at least $250 billion in assets may need to be written off or retired early as climate change causes higher temperatures. Among those assets are buildings in high risk flood zones and power plants that may have to be shut down in response to tighter pollution rules.2 A report issued earlier this year by the Bank for International Settlements in Switzerland, an umbrella organization of the world’s central banks, argues that climate change will cause the next financial crisis.3

Climate change is having an immediate effect on the financial markets. According to the global credit rating agency Moody’s Investors Services, it will soon be a growing negative credit factor for issuers without sufficient adaptation and mitigation strategies.4 The Moody’s report, Evaluating the impact of climate change on U.S. state and local issuers, quoted its vice president as warning that even if states and municipalities adopt mitigation strategies for extreme events, “costs to employ them could also become an ongoing credit challenge.” According to Moody’s analysis of economic strength and diversity, “access to liquidity and levers to raise additional revenues are also key” to its assessment of climate risks, along with “evaluating asset management and governance.”

In direct response to climate-related natural disasters of 2017, the U.S. Congress appropriated $136 billion for recovery efforts.5 In 2019, there were 14 weather-related disasters in the U. S., each causing damages in excess of $1 billion, the fifth year in a row in which 10 or more such disasters occurred.6 The National Oceanic and Atmospheric Administration (NOAA) reports that the average number of disasters giving rise to over $1 billion in damages in the U.S. in the last five years is more than double that amount over the past four decades.7

The United States Fourth National Climate Assessment Report (November 2018) concludes that climate change is increasing the number of new risks and exacerbating existing vulnerable communities, challenging safety, quality of life and economic growth.8 The report also warns that climate-related global warming “is expected to cause substantial net damages to the U.S. economy throughout this century, especially in the absence of increased adaptation efforts.”9

State and local governments’ ability to shoulder these increased costs of disaster relief is very limited since they cannot borrow money as the federal government can. Consequently, they turn to federal relief agencies for help. However, along with other factors, such as banks offloading risky mortgages to Fannie Mae and Freddie Mac10 and FEMA’s $20.5 billion NFIP debt,11 the federal government’s sharply increasing disaster spending threatens its low borrowing cost. The U.S. federal deficit exceeded $1 trillion in 201912 and is expected to reach $4 trillion this year.13 Fitch has noted that a short-term risk of downgrades in U.S. credit ratings increases in light of economic trauma and as debt projections rise.14 To fund climate-related disasters as projected, this debt will only continue to rise. The global investment management firm, Black Rock, has estimated there will be a 275% increase in major hurricane risk by 2050 under a scenario that assumes the continued use of fossil fuels without the necessary steps needed to address climate change consequences. As a part of its analysis, Black Rock’s white paper on the subject points to the Moody’s warning that climate change will affect the future credit worthiness of state and local issuers.15

As recently as September 2020, a subcommittee of the federal regulator overseeing the nation’s commodities markets, the Commodities Future Trading Commission (CFTC), issued a landmark report warning that climate change threatens the U.S. financial markets as the cost of disasters such as wildfires, storms, floods and droughts cause major and devastating impacts on the insurance and mortgage markets, pension funds and other financial institutions.16 The 196-page report is the first wide ranging federal government study focusing on the risks of climate change on Wall Street. The report calls for many climate-driven policy changes in order to avoid the most immediate effects of climate change, which it identifies as falling home prices and rising mortgage default rates in areas where storms, fires and other disasters regularly occur. Among the report’s express recommendations is to put a financial price on carbon emissions that can either be taxed or paid for by a trading system involving credits. The report also recommends the reversal of a Labor Department rule that forbids retirement investment managers to consider environmental impacts in making financial recommendations. Finally, the report makes the case for other agencies, such as the SEC, to strengthen requirements that climate change impacts be disclosed or considered when reporting on companies’ financial stability.

Mitigation strategies

Around the world and in the U.S., the fight to halt the advancement of climate change and to minimize its effects has taken many forms. Among them is a fascinating system to control the effects of severe flooding in the Netherlands. Only 50% of the Netherlands is more than a few feet above sea level, making it one of the most flood prone areas in the world. The geography of the Netherlands is such that fierce storms with hurricane strength winds coming from the North Sea cause enormous storm surges. After a 1953 storm that broke levees and dikes, killing almost 2,000 people, the Dutch government put in place an elaborate system of flood infrastructure and has continued to tweak the system as data mandates. As a result, the Dutch have not suffered a death from flooding in 65 years. The original system took six years to build and cost over $500 million.17

In the 1990s, when flood waters eclipsed the original infrastructure of barriers and gates, the Dutch implemented new and improved flood prevention projects to adapt, making them a leader in knowledge and expertise to other vulnerable nations.18 The post-1990 programs, called Room for the Rivers, give more space to the water rather than trying to confine it. By allowing the rivers to expand when large volumes of water are present, the Dutch have ceased fighting against water and instead are living with it in many instances. They accomplish this in part by buying out residents in flood prone areas and by allowing certain areas to flood to keep others from flooding. The Dutch now describe their flood management system as one that practices protection, prevention and preparedness.19

Communities in the east coast of the U.S. experienced Hurricane Florence flooding in 2018 (dumping record rainfall of more than 35 inches in North Carolina alone) which destroyed thousands of houses and cost dozens of lives. Only two years earlier, Hurricane Matthew caused similar damage to the area. Before that, it was Hurricanes Katrina, Sandy, Harvey and Maria, costing hundreds of billions of dollars in losses. Unlike the government system of flood management in the Netherlands, in the U.S., the general model has long been to pay people for their storm damage and allow them to continue to rebuild at the same location. In this regard, the U.S. disaster system is deemed solution-oriented (rebuilding and repairing) while the Dutch system is based on prevention of impacts from unpreventable flooding.

This year, however, several federal agencies have taken steps to address aspects of disaster relief policy that will serve to shift the U.S. to a model much closer to that of the Dutch, commonly known as managed retreat. In August 2020, the Federal Emergency Management Agency (FEMA) detailed a new program (Building Resilient Infrastructure and Communities) costing some $500 million initially, with billions to follow, to pay for large scale relocations nationwide.20 The program represents a major federal change in policy, since it recognizes the fallacy of rebuilding over and over after successive floods and other disasters and is designed instead to pay for large scale relocations nationwide. In addition, the Department of Housing and Urban Development (HUD) has initiated a similar $16 billion program21 and the Army Corps of Engineers has implemented a policy that requires local governments to agree to force relocations or forfeit flood protection project monies.22 The HUD program is the first time these types of funds have been used to prepare for disasters that have not happened yet. This major move by the federal government to finance buyouts on a large scale represents a broad political and psychological shift in U.S. disaster policy.

In the U.S., however, there is a series of other smaller scale proposed climate change mitigation initiatives on the table. One of those, put forward by the Smart Surfaces Coalition, a group of 30 partners, including the National League of Cities and the American Institute of Architects, proposes a strategy advocating changes to exterior surfaces. This strategy includes the use of highly reflective roofs, porous and reflective pavements, roads and parking lots, green roofs and trees. According to the Coalition, these strategies, if implemented, will change the management of such weather conditions as heat and rain, leading to reduced costs and risks. Cities implementing these changes can expect to experience positive impacts on their livability, safety and comfort. Experts predict, however, that cities not implementing smart surface strategies will likely encounter increased climate-related losses, increased reduction of credit ratings and resulting increases in the costs of borrowing, all leading to the significant risk of municipal insolvency. The net present value of nationwide adoption of smart surfaces is $7 billion, according to the Coalition.23

Another initiative addresses climate risks to outdoor workers, who are facing increasing health threats as a result of climate induced higher temperatures. These risks include dangerous increases in blood pressure, dehydration and organ failure, all induced by heat, aided by humidity. For example, in a four-year span, UPS reported some 107 known heat-related hospitalizations among its drivers. It is highly likely that heat illnesses at UPS among drivers is much higher than that reported because heat illness can resemble other illnesses, and heat induced heart attacks can go unrecognized.24 UPS is not alone. Mail deliverers, construction workers and farmers are among the many outdoor workers in large industries who perform their work under dangerous conditions.

In response to these dangers, UPS initiated a program called “Cool Solutions,” which requires employee education on heat illness symptoms. Others have proposed additional solutions that include:

  • Making shade breaks mandatory
  • Investment in breathable fabric uniforms
  • Investment in wearables that monitor employee body temperature and heart rates
  • Installation of cooling gel seat materials for delivery vehicles, at a minimum

Ultimately, however, it is major action by the U.S. and other governments globally that will play the largest role in decreasing the financial and other risks of climate change. Government actions are needed to reduce greenhouse gasses and property exposures to climate-related storms and other disasters. Among proposals long considered is a carbon tax. Carbon taxes could stem the rising costs of addressing climate change as they increase revenues and encourage critical industries to reduce emissions. In this way, credit rating downgrades may be avoided, and future disasters relating to carbon emissions may be decreased or averted.

Insurance/financial services industry response

The response to the threats of climate change by the insurance and financial services industries has been swift and has real promise. In general, the industries are taking greater control of adapting to climate-related risks. Among the initiatives that have been introduced are climate stress testing for financial disclosures and growing teams that analyze and evaluate natural hazard risk and weather extremes. The financial services sector is seeing a growing demand from clients for:

  • Risk and scenario modeling using the latest science
  • Climate risk audits and stress testing
  • Asset analysis based on environmental, social and governance principles and development of more sustainable climate-resilient portfolios
  • Analytical support for climate-related financial reporting and other regulatory requirements

Willis Towers Watson launched Climate Quantified at the World Economic Forum in 2020 after successful deployment of tools and experts with partners and clients during 2019. Currently, we are working with clients around the world to quantify climate risk and support current and future climate risk management.

Our experience proves that insurance can incentivize risk-smart behavior and stewardship of the environment. Among Willis Towers Watson’s insurance solutions are policies for coastal and terrestrial natural capital, insurance structures that de-risk investments in marine parks and ecosystem restorative projects. Willis Towers Watson tools include:

  • Using catastrophe modeling to understand and quantify risks to natural capital
  • Designing insurance products that de-risk natural capital investments
  • Increasing natural capital “bankability”

Each solution benefits from close collaboration with environmental nonprofit organizations, community leaders and business beneficiaries to bring financial protection to nature-based solutions, to provide economic relief in the face of disruption and to incentivize nature-based solution stewardship.

We offer parametric insurance solutions, a breakthrough in the accessibility of risk financing for climate/natural disasters. Designed to provide fast liquidity in times of crisis, parametric solutions focus on the financial impact of an event rather than on the loss and thus transfer the financial impact to the reinsurance capital markets. This allows for rapid settlement and reduced costs of claims adjustment/processing. While traditional insurance has certain limitations (loss adjustment process is expensive and time consuming, pays only if weather damages owned assets and does not cover wide area disruption), parametric expertise has taught important lessons relating to interim liquidity, flexible coverage, transitioning to pre-disaster risk reduction and risk pooling.

Disclaimer

Willis Towers Watson hopes you found the general information provided in this publication informative and helpful. The information contained herein is not intended to constitute legal or other professional advice and should not be relied upon in lieu of consultation with your own legal advisors. In the event you would like more information regarding your insurance coverage, please do not hesitate to reach out to us. In North America, Willis Towers Watson offers insurance products through licensed subsidiaries of Willis North America Inc., including Willis Towers Watson Northeast Inc. (in the United States) and Willis Canada, Inc.

1 https://www.axa.com/en/magazine/2019-future-risks-report

2 https://www.cdp.net/en/articles/media/worlds-biggest-companies-face-1-trillion-in-climate-change-risks

3 https://www.bis.org/publ/othp31.pdf

4 https://southeastfloridaclimatecompact.org/wp-content/uploads/2017/12/Evaluating-the-impact-of-climate-change-on-US-state-and-local-issuers-11-28-17.pdf

5 https://fas.org/sgp/crs/homesec/R45084.pdf

6 https://www.climate.gov/news-features/blogs/beyond-data/2010-2019-landmark-decade-us-billion-dollar-weather-and-climate

7 https://www.ncdc.noaa.gov/billions/

8 https://nca2018.globalchange.gov/chapter/1/

9 https://nca2018.globalchange.gov/

10 https://www.nytimes.com/2019/09/27/climate/mortgage-climate-risk.html?campaignId=7JFJX

11 https://www.insurancejournal.com/blogs/right-street/2018/09/13/500996.htm

12 https://www.nytimes.com/2020/01/13/business/budget-deficit-1-trillion-trump.html

13 https://www.washingtonpost.com/us-policy/2020/04/18/record-government-corporate-debt-risk-tipping-point-after-pandemic-passes/

14 https://www.fitchratings.com/research/us-public-finance/fitch-affirms-united-states-at-aaa-outlook-stable-26-03-2020

15 https://www.blackrock.com/us/individual/literature/whitepaper/bii-physical-climate-risks-april-2019.pdf

16 https://www.cftc.gov/sites/default/files/2020-09/9-9-20%20Report%20of%20the%20Subcommittee%20on%20Climate-Related%20Market%20Risk%20-%20Managing%20Climate%20Risk%20in%20the%20U.S.%20Financial%20System%20for%20posting.pdf

17 https://www.cbsnews.com/news/storm-water-management-dutch-solution-henk-ovink-hurricane-damage-60-minutes-2019-07-21/

18 https://www.pri.org/stories/2017-07-16/netherlands-always-vulnerable-floods-has-new-approach-water-management

19 See also 20Netherlands.&text=Dikes%20are%20being%20lowered%2C%20spillways%20created

20 https://www.fema.gov/grants/mitigation/building-resilient-infrastructure-communities

21 https://www.housingwire.com/articles/49768-hud-details-plan-to-release-16-billion-in-disaster-mitigation-funds/

22 https://www.nytimes.com/2020/03/11/climate/government-land-eviction-floods.html

23 https://smartsurfacescoalition.org/

24 https://www.nbcnews.com/business/economy/hot-seat-ups-delivery-drivers-are-risk-heat-stroke-kidney-n1031321

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