David Worsfold
We may have a climate change sceptic in the White House who threatens to pull the United States out of the hard-won accord signed in Paris in December 2015 (Climate Changes for Insurance Portfolios), but unfortunately the challenges climate change poses to insurers are not simply going to go away with a bit of wishful thinking.
Stranded Assets: the transition to a low carbon economy: Overview for the insurance industry is a wake-up call to the insurance industry to look hard at the assets it holds and ask itself some serious questions about how vulnerable they may be if even the more modest predictions about the progress and impact of climate change become reality. The study, carried out by Lloyd’s of London in partnership with the University of Oxford Smith School of Enterprise and the Environment warns that the insurance industry could face asset-stranding and liabilities on a global scale as a result of climate change.
It looks at the impact of climate change-related regulation and taxation policies and how they could create “stranded assets” – assets that are subject to a sudden or unexpected write-down or devaluation. The report found this to be especially relevant for insurers and reinsurers exposed to vulnerable carbon-based assets and liabilities in the energy, commercial property and shipping sectors.
The report recommends that firms should stress-test portfolios to build a picture of potential exposure to stranded assets and consider the specific environmental characteristics of investments in their portfolios. For some insurers, there could be a painful double-whammy from the same climate-related event of costly liabilities hitting the balance sheet and the value of assets being written down almost overnight.
Ben Caldecott, director of the Sustainable Finance programme at the University of Oxford Smith School, said: “Insurers and reinsurers price environment-related risks in their insurance policies but don’t always apply these same principles to their investments. Doing so would help avoid stranded assets and ensure investments are appropriately protected in order to meet liabilities.”
Changes to the physical environment driven by climate change, and society’s response to these changes, could potentially strand entire regions and global industries within a short timeframe, leading to direct and indirect impacts on investment strategies and liabilities, argues the report.
It looks at a series of actual and potential examples of how stranded assets caused by societal and technological responses to climate change could affect assets and liabilities in the insurance and reinsurance sector. Its authors say they want to increase the understanding and awareness of these issues in the industry. To do so, it analyses eight asset-stranding scenarios and how they might impact various business sectors:
- Oil and coal reserves become stranded due to international, top-down carbon budget constraints.
- Third-party liability claims against companies, and their D&Os, responsible for climate change.
- Premature closure of coal power stations due to concerns about climate change and the fossil-fuel divestment campaign.
- An increase in political risk events due to government energy policies induced by climate-change concerns.
- Residential solar PV and electricity storage, in part connected to electric vehicles, impairs the centralised electricity generation market.
- Mandatory energy efficiency improvements reduce the value of the least efficient housing stock and increase the value of the most efficient housing stock.
- Property industry professionals and governments are sued for negligence for not disclosing, reporting, or being misleading on the climate change impacts for investors.
- Pressure to reduce carbon emissions increases the value of newer, more efficient ships, and reduces the value of older ships.
The broader implications of climate change for the insurance industry are not by any means a new topic. The Prudential Regulation Authority flagged up many of them in its September 2015 report The impact of climate change on the UK insurance sector (http://www.bankofengland.co.uk/pra/Documents/supervision/activities/pradefra0915.pdf) and they were underlined by the governor of the Bank of England in a speech at Lloyd’s a few weeks after its publication.
“The UK insurance sector manages almost £2tn in assets to match liabilities that often span decades. While a given physical manifestation of climate change – a flood or storm – may not directly affect a corporate bond’s value, policy action to promote the transition towards a low-carbon economy could spark a fundamental reassessment.
“Take, for example, the IPCC’s estimate of a carbon budget that would likely limit global temperature rises to 2 degrees above pre-industrial levels. That budget amounts to between 1/5th and 1/3rd world’s proven reserves of oil, gas and coal. If that estimate is even approximately correct it would render the vast majority of reserves “stranded” – oil, gas and coal that will be literally unburnable without expensive carbon capture technology, which itself alters fossil fuel economics.
“The exposure of UK investors, including insurance companies, to these shifts is potentially huge”, said the governor.
He also urged insurers to be alive to the opportunities that go along with the transition to a low carbon economy.
“Financing the de-carbonisation of our economy is a major opportunity for insurers as long-term investors. It implies a sweeping reallocation of resources and a technological revolution, with investment in long-term infrastructure assets at roughly quadruple the present rate”.
Top of his concerns, however, was the regulatory risk.
“From a regulator’s perspective, the point is not that a reassessment of values is inherently unwelcome. It is not. Capital should be allocated to reflect fundamentals, including externalities. But a wholesale reassessment of prospects, especially if it were to occur suddenly, could potentially destabilise markets, spark a pro-cyclical crystallisation of losses and a persistent tightening of financial conditions”.
The new Lloyd’s report sets out the key actions that companies including insurers, could take in their role as investors to identify and mitigate their stranded asset risks. The PRA will be expecting more than a passing acknowledgement that chief investment officers have these actions on their agendas.