Are we mispricing climate risks or not pricing them at all?

Are we mispricing climate risks or not pricing them at all?
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Τhis February, extremely low temperatures brought the Texas power grid close to collapse, causing blackouts that left millions of people without electricity. For utility companies, environmental challenges of that scale can be disastrous. Think of PG&E, California’s largest electricity provider. Burdened with liabilities of $30 billion, following acceptance of its responsibility for around 1,500 fires, the company filed for bankruptcy in 2019. Although PG&E managed to make a comeback last June, its ordeal marks the first major corporate victim of climate change.

Unfortunately, more may come. Economic losses linked to natural catastrophes amounted to a staggering $190 billion in 2020, according to Swiss Re, with insured losses estimated at $81 billion. The IMF has recently warned equity investors that they are not sufficiently pricing climate change risks. Reasons abound, from the absence of regulation to difficulties in calculating risk and, surprisingly enough, lack of awareness of the problem. However, the stakes are huge — the value of global financial assets at risk has been estimated at $4.2 trillion by the Economist.

Regulators have the power to get the ball rolling. The Paris Agreement formalizes the obligation of investors to include climate change planning in their investment strategies. The Prudential Regulatory Authority (PRA) of the Bank of England has set out a list of priorities for banks and insurers in terms of long-term climate risk management. Their boards, the PRA recommends, must assess “the distinctive elements” of climate-linked financial risks and take a long-term view “beyond standard business planning horizons”.

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The Task Force on Climate-related Financial Disclosures suggests that financial services firms should adopt climate change risk reporting, and ideally include it in financial filings. The million-dollar question is of course whether that would be mandatory. Smaller firms may cry foul, raising concerns over costs and onerous red tape.

If there is one sector that has to up its game, it’s the insurance industry. The growing gap between economic and insured losses certainly raises relevance issues around the sector’s catastrophe modelling tools predicated on long-term climate stability.

These issues are increasingly important when it comes to infrastructure development, a key driver in governments’ initiatives to reset the economy. The new U.S. administration and the EU have stressed the need for investments in green infrastructure as a part of their recovery plans.

The problem is that investments in infrastructure, a sector particularly vulnerable to climate change, require long-term insurance products. And yet, these cannot be developed if the risks are not well understood, disclosed and priced. Without proper risk assessment, infrastructure insurance premiums will remain uncompetitive. And if infrastructure investors do not price climate risks into their models, their return expectations will be inaccurate at best. Think of the insurance premiums that would be necessary to build iconic infrastructure in our times. How many investors would dare to fund construction in New York City today without reliable climate risk assessment and insurance coverage?

One way to solve this conundrum is to develop and tap into data that can help insurance providers and investors better assess risk. For example, one powerful tool they can use is Earth observation data such as water cycles and distribution, flooding land use and heat mapping. As the Harvard Business School academic Rebecca Henderson notes in her influential book “Reimagining Capitalism,” environmental, social and corporate (ESG) metrics, which capture the costs and benefits of tackling environmental and social issues, can convince investors that green, rather than greed, is good. One reason why many investors are hopelessly short-termist, Henderson argues, is that they don’t have reliable data.  

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The insurance sector has to invent a radically different price discovery mechanism for these products. If investors are buyers of climate risk and insurance providers are the sellers, they both face the same problem: radical uncertainty. The models currently used for climate risk pricing are inadequate at best. One reason is that they are based on equally insufficient climate forecasting models and often imply that climate change is a long-term phenomenon that is best priced in the future.

For their part, investors such as pension funds are also in the dark, and often face unsavoury binary choices: To build or not to build?  In other words, they are buying something without knowing its real price and having to make assumptions about insurance availability and affordability over the medium-term while projects are still being built. To complicate things further, insurance companies are investors themselves, as they happen to be large real asset owners, particularly in Europe.

Both policymakers and insurers have recognised the need to develop better pricing models. This is why there is a host of organizations and initiatives working toward that direction, including the UN Environment Programme’s Principles for Sustainable Insurance Initiative, the Insurance Development Forum, the Coalition for Climate Resilient Investment, and the InsuResilience Global Partnership for Climate and Disaster Risk Finance and Insurance Solutions. As in other areas of green finance, there is an obvious overlap of responsibilities. We need a multilateral, coordinated approach that would bring all stakeholders to the same table and foster the development of solutions that address these challenges.

We cannot avoid natural disasters. But we can put the right price tag on them. One can hope that soon, a marketplace will evolve where insurance providers and investors could work together and come up with solutions.

Abhisheik Dhawan is the sustainable finance and partnerships specialist with the UN Capital Development Fund (UNCDF), which makes public and private finance work for the poor in the world’s 46 least developed countries which makes public and private finance work for the poor in the world’s 46 least developed countries. The views expressed by the author are personal.