Measuring climate change’s true cost

When the financial consequences finally sink in, people will — perhaps — start taking climate change more seriously and make the tough decisions needed, writes Kyran Fitzgerald.

The impact of the global environmental upheaval is being felt in myriad ways.

The most recent examples include a record breaking heatwave in Australia, deadly wildfires in California, and the strange polar vortex event that brought the worst freeze in over 40 years to the US mid-west along with temperatures in the Arctic that are way above average.

It would be tempting to start delving into the changing lives of polar bears and crocodiles, some of whom have been swept recently into Queensland homes by flooding waters.

Let’s resist that temptation and relocate to the head office of the Central Bank on Dublin’s North Wall Quay, where the governor Philip Lane had some interesting things to say on this topic last week.

In an economic letter, Mr Lane dwelt on the topic of ‘Climate change and the Irish financial system’.

“Climate change will be an important influence on macro-economic outcomes,” he pointed out.

Mr Lane is tipped to take over shortly as the ECB’s chief economist. His views will matter.

He is signalling to the establishment — political, bureaucratic and business — that we simply can no longer ignore the elephant in the room, now that the mighty mammoth is leaving a mess on the carpet.

In this regard, he signals that the “necessary transition to a low carbon economy requires considerable investment by households, firms and the Government.”

Moreover, it is vital that we act now rather than later in panic when the measures taken would have to be much more drastic and, therefore, more damaging to the economy.

“If the pace of transition is too slow, a sharper adjustment will ultimately be required posing macroeconomic and financial stability risks,” Mr Lane said.

Pay up now — or end up paying a hell of a lot more later, is the message. The experts are increasingly factoring matters climatic into their calculations.

The US-based Brookings Institution research group points out that policy responses to climate change could have important implications for monetary policy — and vice versa.

In a recent paper, it suggested that one should think of the impact of climate disruption and policies to combat global warming as supply shocks in their own right.

Extreme weather events cause sharp but temporary spikes in the price of food and other raw materials as well as huge damage to infrastructure and property. But moves to tackle emissions will permanently affect the price of fossil fuels with effects ratcheting through the supply chain.

This all means that prices become more volatile, presenting central bankers with a real challenge.

The paper’s authors warn that “an inappropriate monetary response could lead to a wage-price spiral as people find it hard to forecast inflation.”

The best approach to tackling carbon dioxide emissions is one of ‘steady as she goes’. A few contrasting scenarios are laid out.

Scenario one is where a carbon tax starts now at $15 (€13.25) per ton of CO2 and rises by 4% above the rate of inflation.

Scenario two is where the tax comes in at $25.50 in eight years’ time and then rises by 4% above inflation.

The third is where it comes in at $15 in eight years and then jumps by 10% above inflation annually.

No prizes for guessing which scenario is the preferred one from the point of view of policymakers. Grasp the nettle now and you start sending signals to the wider economy.

The tax on coal would be much higher than that on natural gas because of the higher carbon content and general dirtiness of the former. But clearly, renewables would fare best. Carbon taxes would allow more effective signalling to businesspeople and consumers.

But central bankers, too, must accept that an inflationary hit will have to be absorbed in the short-term as the tax kicks in. The politicians, of course, baulk at this, which is why the public must be won round. Mr Lane recognises the need for careful messaging but are all his central banker colleagues, never mind the politicians and business folk, on board?

One approach is to accentuate the positives. Carbon tax receipts do not disappear into thin air. They can be put to good use. As Brookings puts it, “the ultimate impact of a carbon tax depends on how the revenue it raises is used.”

It recommends the focus is on cutting taxes on wages and salaries with arguably, indirect taxes also being cut. 

Carbon taxes can end up reducing tax distortions while also boosting new industries. Central bankers can play their part through well-targeted quantitative easing.

Emissions trading was heavily touted, but has worked less well at EU level than expected. But some economists believe that a hybrid of tax and trading permits could work well, with price ceilings on carbon prices being applied during economic downturns.

Tax credits have been extensively used to promote wind and solar, for example. The concern is one ends up subsidising uneconomic activity, but when combined with carbon taxes, trading and tough regulation, such credits could perform a useful stimulatory role.

The insurance industry finds itself at the sharp end of climate change.

In 2017, the cost of natural disasters reached $330bn globally by some estimates. This compares with an average of $170bn over the preceding decade.

The insurance industry in 2017 paid out a record $135bn on natural catastrophes, almost three times the previous annual average of $39bn. This figure, of course, excludes the huge cost to the uninsured — or underinsured — which falls on governments or on the individuals themselves.

General insurers are canaries in the financial coalmine. Natural hazards cost QBE, one of Australia’s top three insurers, $1.7bn, or 15% of net earned premiums. This is twice the normal average. The reinsurers — who insure the insurers — have taken the biggest hit. Some have been forced to flog their holdings of equities. The insurers should be crying out, but are they?

A 2012 study by Andrew Hoffman of the University of Michigan, showed only 12% had a climate change strategy, though this has risen to 38% in 2018.

The real insurers have been slow to react because up to now, they have been able to pass on the cost to reinsurers, but the ground here is giving way.

To date, insurers have followed a strategy of quietly adjusting their policies upwards, but analysts warn that this approach is over complacent.

Change is happening. According to the International Association of General Insurance Supervisors, many insurers have thrown out their accumulate weather data and have hired teams of in-house climatologists, computer scientists, and statisticians, to redesign their risk models. And about time, too.

The hard reality is that much higher premiums are on the way and nothing can now prevent this. The industry needs to start speaking out much more strongly on an issue where climate deniers retain far too much influence as evidenced by news of the appointment of a climate change sceptic, David Malpass, from the US treasury department to the presidency of the World Bank.

Mr Lane has signalled that he, at least, smells the coffee, so to speak, and recognises the threat to the global financial system posed by a process of runaway climate events. Let’s just hope that more of his colleagues come on board and do so forthwith.