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The author is a former senior vice president of the World Bank
When the Titanic set sail in 1912, it was considered unsinkable because the hull consisted of 16 watertight compartments. The ship would still be afloat if four of its compartments were damaged, according to reports. Similar assumptions underpin today’s international financial architecture facing multiple crises: runaway climate change, financial fault lines, health pandemics, geopolitical dangers, next-generation artificial intelligence, and global water and food scarcity.
International leadership seems to think that if two or more crises erupt at the same time, the system will remain afloat. This assumption is clearly wrong. The interaction of the climate crisis and financial vulnerabilities poses potentially insurmountable dangers unless immediate action is taken.
Global debt has reached unprecedented levels, putting pressure on a system still reeling from the pandemic. A shadow banking system of “non-bank financial intermediaries” emerged after the 2008 financial crisis and now dominates around half of global financing. Unregulated financing of NBFIs is about $240 trillion.
At the same time, both the IMF and the World Bank are facing difficulties in simultaneously addressing pandemic-induced poverty and escalating demands from climate change. Other risks, such as Russia’s war in Ukraine, add to the burden on the system. It is against this backdrop that a worse-than-expected climate crisis could lead to the collapse of the global financial system.
16 climate tipping pointsIn an article published in the journal Science, a team of researchers identified this as a trigger for a possible collapse of highly leveraged global financial markets. Markets, including regulators and central banks, have failed to integrate the physical, transition and liability risks of climate change into observable market data.
Here’s an example: Imagine if the five largest property and casualty insurers and the three largest reinsurers collapsed due to previously unlikely ice cap melting and permafrost collapse, which would lead to flooding. Insurers will face unprecedented claims and slashed portfolios, depleting their capital bases.
In addition, the impact of climate change on food shortages and collapsed supply chains will make the system even more vulnerable. Price levels would surge as the global financial system floods with liquidity as a result of defensive actions such as central bank bailouts. Banks will be knocking on the central bank’s door to fend off the fallout from insurer defaults.
Global action now presupposes the recognition that a crisis that once seemed distant has arrived. Its reversal depends on a full-scale effort to decarbonize the economy.
This forces the G20, which accounts for 80 percent of global GDP, to take the lead in addressing the inherent fragility of the current architecture. Member States must act quickly to regulate key aspects linked to growing climate dangers, including imposing bank capital charges on carbon-intensive activities.
In addition, the G20 should impose a carbon price high enough to make using fossil fuels more expensive relative to clean energy, and instruct governments to reallocate the more than $5 trillion in fossil fuel subsidies they collectively provide each year. These measures will help reduce the concentration of carbon dioxide in the atmosphere to 350 parts per million, which scientists believe is a sustainable threshold.
In addition, regulators and central banks need to incorporate liability risks from climate change into market data. This means that financial markets need to ensure that securities with lower climate change exposures or stronger mitigation commitments have lower costs of capital.
Globally, climate damage is translating into billions of dollars in unpriced losses, sending shockwaves through crumbling systems. To meet this challenge, the COP28 presidency should jointly establish a $100 billion adaptation fund among OPEC countries. The resulting proceeds will ease the immediate needs of the most vulnerable countries.
Active intervention at the global level is unnecessary if markets include public functions and not just private ones. But in 2008, reliance on markets led to a global financial crisis. That seems trivial compared to the financial crisis that climate chaos could bring.
When divers reached the wreck of the Titanic on the ocean floor, they found the hull almost intact. Damage to an area caused it to sink. To avoid a similar fate, the G20 must use its unique platform to act now.
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