Tag: Climate Change

What Are the Economic Impacts of Climate Change?

Strategically, the economic risks relating to the changing climate are one of the most significant challenges we face. But what are the potential long term impacts likely to be? In this Federal Reserve of St. Louis, on the economy blog,  this important subject is explored.

We think there is a need for similar modelling to be done in Australia, as many of the most populated areas are most likely to be impacted.

How might climate change impact the economy over the long term? Some potential impacts include increased mortality, higher demand for electricity and reduced yields for certain crops.

At a recent Dialogue with the Fed presentation, William Emmons, lead economist with the St. Louis Fed’s Center for Household Financial Stability, highlighted research1 that identified geographic “winners and losers” on a county-by-county level across the United States.

Looking out to the year 2090, the findings showed that the St. Louis region could expect a significant impact on its economic activity, Emmons said.

“And if you zoom in and look at our region, [the researchers’] estimates are that we could lose the economic equivalent of 5 to 10 percent of GDP as a result of these effects,” he said, noting that impacts would be gradual.

How the Fed joined the fight against climate change

From The Conversation.

The Federal Reserve’s policy committee is expected to lift its target interest rate a quarter-point – to a range of 0.5 percent to 0.75 percent – at its final meeting of 2016.

The main reasons the Fed has kept rates near zero for eight years have been to restore economic growth and lower unemployment – goals that have been largely achieved. But doing so has had an important, if little noticed – and probably unintended – side effect: It has been promoting efforts to curb global warming.

Solar projects like this one in Pueblo, Colorado, become more attractive when rates are very low. Rick Wilking/Reuters

That is, the ultra-low interest rates have favored sustainable projects like wind farms and corporate solar installations, the kind that are necessary if the world is to transition to a low-carbon future in line with the Paris climate accord. At the same time, they have discouraged unsustainable, high-carbon projects like coal power plants that appear cheap but become unprofitable over time when you factor in the cost of carbon.

Government policy, without help from the Fed, could nudge businesses and consumers to reduce carbon emissions. But, as my research shows, governments walk a fine line when setting carbon policies. They may fail to adequately address climate risks with policies that are too lenient or come too late or they may create systemic instability and financial crises with policies that are too harsh or aggressive.

So one way to reduce these risks is for the business sector to voluntarily and swiftly proceed with the transition to a low-carbon, “green” economy. And thanks to the Fed, the low-interest rate environment is supporting just that.

Opportunity costs

Under the Paris Agreement, more than 190 countries agreed to limit the global temperature increase to below 2 degrees Celsius.

Just last month, the agreement entered into force after countries representing 55 percent of global emissions ratified it.

But the accord doesn’t actually force countries to do anything to live up to their pledges, and many companies have long been resistant to the kinds of policies, like carbon taxes and cap-and-trade systems, that would achieve those aims. Furthermore, U.S. President-elect Donald Trump has vowed to exit the accord.

So how can we reach those goals?

My own research suggests one way to get there is through the widespread adoption of capital budgeting techniques – the process of determining the viability of long-term investments – that take into account the opportunity costs of both financial capital and carbon dioxide.

The opportunity cost of financial capital is simply the rate of return the company could have earned on its next best investment alternative. If a project cannot return at least that, it should not be funded.

On the other hand, atmospheric capital, as measured by carbon dioxide emissions, is not privately owned, making its opportunity cost much harder to measure. This cost includes the benefits we forgo when emitting carbon dioxide into the atmosphere, such as more stable agricultural yields, reduced losses from less violent weather, greater biodiversity, etc. If a project cannot generate a return on carbon that is at least commensurate with the benefits we give up as a result of the project’s carbon emissions, the project should be rejected.

Estimates of the social cost of carbon for the next 35 years have been produced by the U.S. Interagency Working Group on Social Cost of Carbon and other organizations, such as Stanford University. Estimates from these two sources range from approximately US$37 to about $220 per ton of carbon dioxide, while many companies report internal carbon prices at or below the lower end of this range.

Historically, companies creating these costs haven’t borne the brunt of it, but that is changing as countries, states, provinces and cities are imposing or planning to impose various carbon pricing mechanisms. Examples include China, the European Union, California, Canada and U.S. states in the Northeast and Middle Atlantic region.

Since the planning horizon for long-term capital budgeting projects like power plants and solar installations often extends out 10 to 20 years or more, that carbon cost is likely to grow quite a bit, and more of it will be billed to the companies doing the polluting, meaning carbon-intensive projects will become increasingly expensive.

While the Fed does not influence the opportunity cost of carbon – and whether companies account for it – it does influence the opportunity cost of financial capital. Specifically, the Fed influences the time value of money by setting interest rates.

Patient investors

The time value of money is the compensation borrowers pay investors for their patience.

If the interest rate is high, people are very impatient and prefer cash flows now, perhaps leading them to prefer to invest in a polluting power plant that pays out right away rather than an expensive windmill farm. If the interest rate is very low, on the other hand, people have easy access to funding and can wait a long time for cash flows that come much later. That makes longer-term, riskier projects like that windmill farm more attractive because their value will grow as governments punish carbon emitters – and investors will be rewarded for their patience.

It is the Fed’s manipulation of the time value of money that affects the choice of high-carbon versus low-carbon projects, especially when an expected rising opportunity cost of carbon is included in the analysis. So with rates hovering at unprecedented lows for nearly a decade, today’s investors can afford to be patient.

Investments in the green economy that initially may seem expensive but pay off over the long term are favorably viewed when rates are low because positive cash flows in the more distant future are barely discounted. That is, their present value equivalents (the current worth of a future sum of money) are almost the same as the future amounts because so little interest would be earned were they invested elsewhere. That means the positive future cash flows are more likely to outweigh the initial costs of green projects.

In fact, there has been a solid 57 percent increase in renewable energy capacity in the U.S. since 2008, while dirtier power sources – though still dominant – have waned.

Coal, for example, made up 21.5 percent of energy production in 2015, down from 34 percent in 2008. Renewables, meanwhile, climbed to 11.5 percent from 10.2 percent in the same period. Actual consumption tells a similar story, with coal-making up 16 percent of all energy consumed in 2015, compared with 22.6 percent in 2008. Consumption of renewable energy climbed to 9.8 percent from 7.3 percent.

The expansion of the renewable energy sector was driven by a number of factors including cost reductions associated with technological improvements as well as policy support in the form of tax breaks, but the low-interest rate environment undoubtedly contributed to the acceleration of the low-carbon transition.

Will the music stop?

The Fed has been able to keep the time value of money at record low levels for so long thanks to persistently low inflation. If inflation begins to accelerate as economic growth increases, the Fed no longer has that ability, and the upcoming rate rise will be just the beginning. That will begin to shift the valuations of high- and low-carbon projects, making the former a bit more attractive, the latter a bit less so.

But a quarter-point increase won’t change valuations much. For now, the low interest rates will continue to favor long-term sustainable projects that will help us reach the Paris targets, while discouraging unsustainable ones that become unprofitable once budgeting analyses consider the likely future implementation of carbon taxes and new emissions regulations.

If we do reach those targets, we would have the Fed and the markets to thank – and not Congress or Trump – for a successful transition to a low-carbon economy.

Author: Carolin Schellhorn, Assistant Professor of Finance, St. Joseph’s University

Sydney’s wild weather shows home-owners are increasingly at risk

Last week we highlighted the timely new report from the Climate Institute, which warned of the consequences of more violent weather on property for owners and their bankers. Just five days before the super storm hit!

From The Conversation.

Eastern Australia’s wild weather has left coastal homes teetering on the brink of collapse, and has eroded beaches by up to 50m in parts of Sydney.

Now the attention turns to the clean-up. There are several legal issues for owners of damaged properties, particularly the question of if and how they can be compensated.

While the recent events cannot be attributed directly to climate change, they are certainly consistent with a warming world. Our institutions are ill-prepared for a potential increase in the frequency and severity of such events.

Insurance

Unfortunately, the success of insurance claims for damaged homes in Sydney will depend entirely on the terms of their policies. Some policies don’t cover erosion at all. Some policies only cover it if it occurs within a certain proximity of another insured event (for example, within 48 hours of a named storm event). Some policies also comprehensively exclude coverage for damage caused by actions of the sea.

What’s more, while insurance will cover damage to buildings, policies do not extend to cover damage to or loss of land. This is especially problematic in the case of damage caused by waves and storms, because erosion will often result in loss of land.

Under the traditional law doctrine, where land is lost to erosion, the Crown automatically gains title to the inundated land, without any obligation to pay compensation. So even if a home-owner is insured, they may find themselves with no land to rebuild on.

Legal proceedings

Another potential avenue for home-owners to pursue is proceedings against the relevant local government for negligent approval of development. The success of this type of proceeding is highly speculative – much will hinge upon when the development was approved and how much information on the coastal hazards was available at that time.

Where development was approved decades ago, it may be difficult to prove that a local government was negligent, because of the limited state of knowledge at the time. In the case of more recent development approvals, there may be an argument that a local government had a high level of knowledge of the risk and control of risk information. These are the type of factors a court will look at in assessing negligence.

On the flip side, a court may also find that a landholder knew of and accepted the risk. Negligence proceedings are by no means a guaranteed avenue for landholders to recoup their loss, but are an avenue that Collaroy landholders may be able to explore.

Disaster assistance

Where insurance is not available, and there are no strict legal rights against government, landholders may request disaster relief or assistance from government.

Despite the lack of any legal compulsion to do so, Australian governments have a long history of providing disaster relief to citizens when an extreme weather event causes property damage.

A recent Productivity Commission report estimated that, over the past decade, the federal government spent A$8 billion on post-disaster relief and recovery. State governments spent a further A$5.6 billion.

However, the availability and amount of a payment are not guaranteed. This may depend upon the number of other claims for assistance, and any other demands on government resources. A claim for disaster relief from government may be an option for Collaroy landholders, but many other home-owners are also affected by flooding due to the recent extreme weather – and so potentially there are many other requests for relief.

What should we learn from this event for the future?

While the pictures of houses being lost to the sea in Collaroy are confronting, these images may become more commonplace. The most recent scientific report from the Intergovernmental Panel on Climate Change suggests that, under a business-as-usual scenario, a global sea-level rise in the range of 0.53-0.97m by 2100 is likely.

Even if emissions are immediately reduced, a global sea-level rise of 0.28-0.60m by 2100 is still possible. This will be especially problematic in Australia, with an estimated 711,000 residential addresses located within 3km of the shore and less than 6m above sea level – not to mention the billions of dollars’ worth of government infrastructure also located in these regions.

As sea levels rise, some properties may be permanently inundated. Others may be hit by storm surge impacts or erosion, which may be exacerbated by sea-level rise.

If these events continue to attract disaster relief, the financial burden will become too great for governments to bear. Furthermore, government disaster assistance does not solve the more intractable problem of land being lost to the sea.

The pictures from Collaroy should therefore prompt a discussion about how we, as a society, can deal with the potential impacts of coastal hazards on existing developments.

This is a challenging question to answer, but there is an opportunity to address it in a planned and co-ordinated fashion.

Author: Justine Bell-James, Lecturer in Law, The University of Queensland

Climate Risks For Property Owners And Their Bankers

Mortgage underwriting is all about correctly assessing risks. How much is the property worth? How big is the loan? How well placed are the borrowers to repay the loan? What is the credit risk? But, according to a new discussion paper There goes the neighbourhood: Climate change, Australian housing and the financial sector by the Climate Institute, banks and their customer need to be more alert to risks associated with Climate Change.

I spoke to the author, Kate Mackenzie, about the paper which highlights important issues for lenders and prospective purchasers. She says banks should be undertaking detailed portfolio modelling to analyse the current and future risks in their property loan portfolios (after all their insurers have the data), and prospective purchasers should be exploring the impacts from floods and other natural forces before purchase (there are tools available, or try getting online insurance quotes for a prospective property). She says that Local Authorities may sometime grant planning approvals on land which is or will become risk prone, and buyers should beware.

The report says that some of the homes built, bought and sold in Australia are vulnerable to flood, cyclone and bushfire, as well as growing risks such as storm surge, landslip and coastal erosion. Australia is highly exposed to climate change and this will exacerbate many of these risks. Whilst It is often possible to “defend” or “adapt” housing to some of these risks, not all are adaptable, and some only at a prohibitive expense.

Unsurprisingly, individual buyers and residents are often unaware of risk levels, particularly rising levels of risk or emerging risks. Even when public authorities, financial institutions and other stakeholders possess information about current and future risk levels, they are sometimes unwilling, and sometimes unable, to share it with all affected parties.Thus, foreseeable risks are allowed to perpetuate, and even to grow via new housing builds. The full scale of the risk may only be recognised either through disaster or damage, or when insurance premiums become unaffordable. Any of these events can in turn affect housing values. Damaged, destroyed or devalued housing has social costs – either to individuals, or to the broader public via government. Australia’s housing stock is expanding, and with continuing gaps in policy, regulations and industry, it is highly likely that some of this new stock is more vulnerable than buyers, residents and other stakeholders would assume.

Virtually all banks, in every year, clearly identified risks of climate impacts to their own operations, and describe measures taken to ameliorate this. Most banks, in most years, cited indirect risk via institutional financing, in particular to the agricultural sector. In some cases, banks described developing and deploying screening methods to ameliorate this risk.

However, references to climate impacts via residential property were far patchier. Several banks, for example, referred to material risks via their customers’ ability to repay mortgages, and even referred to studies of the aggregate exposure of Australian housing to climate impacts. Moreover, the banks’ own industry group, the Australian Banking Association, has been relatively silent on this matter.

Industry has tended to defend its position, but the paper offers some important commentary on their arguments.

1. Property value in land: The assertion that the property’s value is solely in the land rather than the building will be irrelevant in several scenarios, particularly when we consider climate change. For example, there are limitations to measures that can mitigate the effects of coastal erosion. Land that is at increasingly frequent risk of flooding may be still suitable for dwellings, but the increasing cost will reduce the value of the properties. This has been seen in bushfire prone areas.

2. Full-recourse loans protect banks: Australian mortgages are almost universally issued on a “non-recourse” basis. This means that, in contrast to some US states, borrowers cannot simply “hand back the keys” to their lender, thereby offloading their obligations. In Australia, the risk of property devaluation remains with the individual, while the banks are relatively protected from a scenario in which borrowers default on properties that become worth less than the amount of the outstanding loan.

3. Already incorporated into credit risk practices: A review of big four bank submissions to CDP (formerly Carbon Disclosure Project) reveals a broad range of approaches to physical climate risk in the residential mortgage portfolio. While all banks discuss climate impact resilience measures for their own property portfolio (bank branches etc.), and two banks mention incorporating physical climate risk into their commercial lending practices, there is little mention of incorporating physical climate risk into residential property lending risk assessments.

4. Size and distribution of property portfolios mean this couldn’t be material for big banks: Several banks have already disclosed exact amounts of provisioning following natural disasters. In fact, at least three of the big four banks have individually acknowledged there is some risk. Westpac has acknowledged in several CDP submissions that increased flood risk from climate change represents a risk to its mortgage and other loan assets, ANZ in 2007 said it would begin to devise a method to analyse this risk and NAB states that it is exposed to the physical effects of climate change to its customers, not only in residential property, but also as an agri-business lender.

It is true that all amounts of costs incurred to date are small relative to the banks’ overall balance sheets – for example, NAB reported a $76 million provision for bad and doubtful debts associated with the 2011 floods in Queensland and Victoria. However the nature of climate change means these risks will increase – particularly if urban, coastal development continues to grow without adequate resilience standards.

5. Use of mortgage insurance removes risk to banks: Mortgage insurance is taken out by banks to protect against loss from mortgage defaults, particularly where the loan-to-valuation ratio is high, or when the borrower is deemed high risk. Lenders mortgage insurers (LMIs) are the providers of this cover. In terms of financial risk, LMIs will specifically not cover loss due to natural hazards. There is also debate around the role of LMIs in Australia, in terms of their own financial stability and their role in the broader financial system. An RBA report in 2013 noted that while industry practices have mitigated some risks related to LMIs, they are highly correlated to the broader mortgage market. Therefore, in a credit market downturn, LMIs could be procyclical, or at least fail to be counter-cyclical. Another limitation of LMIs is that they only cover about a quarter of all mortgages. The limitations of LMIs as a hedge against mortgage losses are illustrated by mortgage-related losses suffered by several banks due to natural disasters. Finally, Australia’s prudential supervisor, APRA, has explicitly limited the amount of protection that banks can assign to LMI, by placing a floor of 20 per cent for “loss given default” on internal risk-based (IRB) models. This is the same whether or not the mortgage is covered by LMI.

6. Average mortgage duration: Average mortgage age in Australia is thought to be around 4.5 to 5 years. However this is an average from a market that has, in aggregate, grown every year for decades. Although definitive data is not collected on non-securitised mortgage age, it is likely a proportion is due to owners “cashing out” as prices rise. This is unlikely to be a mitigating factor for banks with up to 25-year mortgage exposures on risky properties.

The paper recommends Australian banks should:

  1. examine climate risk to their own mortgage books and ensure it is integrated into their risk assessment processes
  2. use their role as the predominant providers of property development finance to support good policy – both through individual commercial lending decisions and through submissions to and engagement with policymakers
  3. work with other stakeholders – in the public, private and civil society sectors – to research and develop ways to minimise climate impact risk to housing, and to address losses that will occur in an equitable way
  4. actively support the development of: an open and accessible platform for natural peril data, including both historical incidence and projected or emerging risks due to climate change and policy to achieve this outcome
  5. make information publicly available so that market expectations can adjust gradually, avoiding sudden, detrimental impacts.

The Climate Institute is Australia’s leading climate policy and advocacy specialist. Backed primarily through philanthropic funding, the Institute has been marking solutions to climate change happen, through evidence based advocacy and research, since 2007.

The Paris climate agreement at a glance

From The Conversation.

On December 12, 2015 in Paris, the United Nations Framework Convention on Climate Change finally came to a landmark agreement.

Signed by 196 nations, the Paris Agreement is the first comprehensive global treaty to combat climate change, and will follow on from the Kyoto Protocol when it ends in 2020. It will enter into force once it is ratified by at least 55 countries, covering at least 55% of global greenhouse gas emissions.

Here are the key points.