Climate once believed to a poor excuse for weak economic data, has now become a major concern, as experts are speculating that the current cataclysmic climate catastrophes could spur the next global financial crisis. The Bank for International Settlement (BIS)’s S&P global report of last year showed concern about the worsening climate condition and that the world’s central banks are woefully ill-equipped to deal with its devastating consequences.

Have we underestimated the effect of climate change on global financial instability? What ripple effects could climate change make on the global economy? And do we still have any time left to stop this inevitable-looking catastrophe?

Climate Catastrophes and Financial Crisis

Climate change is this decade’s defining issue, as the global temperature is reaching close to the threshold set by the Paris Climate Agreement, more climate-related catastrophes are sticking with higher intensity every year. Along with taking thousands of life, killing millions of animals, destroying acres of forests, and displacing millions from their homeland, the climate crisis is hugely stressing the global economy.

The number of extreme climate calamities has quadrupled in the last four decades, and only 40% of the total financial loss caused due to them are covered in the US, in Asia, the percentage falls to 8%, and in Africa, it stops to only 3%. A study published by Nature dictates that Absolutely no climatic catastrophe in the past 2000 years of earth’s history can resemble today’s global warming.

Professor Paul Griffin of UC Davis Graduate School of Management, says, “Despite these obvious risks, investors and asset managers have been conspicuously slow to connect physical climate risk to company market valuations,”

There is no doubt that the window to come to grips with climate changes is closing fast, the disastrous consequences of the climate crises have become more frequent and damaging in recent years. The global temperature is accelerating exponentially along with the global losses due to climate-related damages.

The problem gets even bigger, when the climate crisis hits systemic countries, as the after-effects can spill across borders, and could adversely affect the global economy. The International Monetary Fund conducted a study on the impact of climate catastrophes on the global economy and trades in 63 countries which together make up 85% of the global GDP. The study highlighted six countries with the largest GDP and most vulnerable to climate change, the research found that any huge climate shock in one of these economic giants, would adversely impact the countries’ external position, and cost the global GDP a loss of $300 billion.

How Will Climate Catastrophes Affect Global Economy?

Hurricanes, wildfires, flooding, extreme heatwaves, and droughts have already lowered many big economies’ GDP in the past couple of years. As these natural disaster’s intensity increases, so will the shock to the countries’ GDP, damage to its physical capacity, and exacerbated its current accounts. Under such circumstances, it would be difficult for these catastrophe-hit countries to access the financial market and pay external debt payments on time.

The financial crisis in one of the systematic countries will surely overspill to other countries associated with direct trade and other financial links, thus increasing their external financing needs. The financial constrain chain will then string cascading to more economies, even those that are not directly linked with the country that is directly hit by the climate crisis.

This final contagion may further amplify as the sovereign risk premia increase with financial risks. Moreover, countries with similar climatic issues would be seen as a bad investment by the global investors, thus negatively affecting such countries’ GDP, and further increasing the financing needs.

How Can Policymakers Be Prepared For Such Scenario?

Revamping and mitigating policies to address the inevitable climate change have become more important than ever. A broad package of measures could help make economies more resilient and sustainable to reach the net-zero emission goal by 2050. According to IMF a mitigating package that includes the following could be the stepping stone toward more environmentally and economically sustainable countries:

  • Gradually increasing carbon prices
  • Compensation for households
  • Green infrastructure investment

Global Financial Safety Net and Microeconomic policies could also greatly help in reducing the contagion. From flexible exchange rates for absorbing shocks to smooth external adjustments are the way, giant economies can adapt to be prepared for climate catastrophes and their ill effects on countries’ GDP.

“Climate change poses unprecedented challenges to human societies, and our community of central banks and supervisors cannot consider itself immune to the risks”, says Villeroy de Galhau, head of Fran├žois, France’s national central bank.

There is still time for these worst-case scenarios from becoming realities. In today’s intimately interconnected world, climate catastrophe is a looming risk to the global economy, and the world’s financial instability. International corporations and policies to address this looming risk could help mitigate the future threat, the time to take action is now.