Forget the Fiscal Cliff - Will the Climate Cause the Next Recession?

Even with the debt ceiling and fiscal cliff looming,  a UN Environmental Program report global suggests that capital markets are vulnerable for another reason- underrated environmental risk. The UN Environmental Program publishes a quarterly “Financial Initiative” brief aimed at the financial sector, often in conjunction with a major banking partner. These briefs are designed to communicate environmental imperatives to analysts. These “Liquidity Reports” warn of threats to the economy presented by water scarcity. October’s issue explains how water supply volatility has not been accurately priced into investments within the extractive industries, primarily mining. The UN’s report highlights great detail on water scarcity, but the financial sector’s failure to recognize environmental risk is much broader than water.

With the exception of a limited number of funds, the financial sector has not accounted for the risk associated with climate change. This is a scary situation because it means that at some point, when climate change becomes irrefutably obvious or regulations force recognition (such as the SEC rules to report ghg output), markets will recognize these risks. The last time the global financial sector realized unappreciated risk was in 2007, resulting in the deepest recession since the 1930's ( for an excellent dramatization of the market's moment of realization, see the film Margin Call). The markets will eventually price commodities closer to their actual value (higher) and more accurately accounting for environmental volatility (also high). In this case, inflated prices would be double strength, caused both by accounting for the climate change weather risk, and accounting for the resource scarcity that results.

Take an example: soybeans.

This commodity staple is globally important for human and livestock consumption. When the droughts in the US Midwest reduced this year’s crop to its lowest output in 40 years, your tofu price ticked up slightly. But worse, it caused a catastrophe in the dairy industry. Lots of American farmers suddenly couldn’t afford feed for their cows. You now have farmers feeding dairy cows candy because it is cheaper . The same story is true for corn. And that was just one notable drought, one year. We are in for a future of this.  Eventually, the combination of economies hammered by climate change and inflation driving up the cost of staple commodities will fundamentally challenge our lifestyles, the way we conduct business, and our experience in the economy.  Not only are we all linked in the environment ecologically, but there is also ecology to finance that links our lives and economy quite directly to environmental outcomes. In this sense “going green” is less a public relations move and more a risk management tool, and should be framed that way.

When environmentalists talk about accounting for “externalities”, this is the level of finance at which that actually happens- in analysts' judgements of the industry risk. It is these judgements that determine credit ratings, asset pricing, setting interest rates, firms' cost of capital, pricing in futures markets, and the stability of the commodities market that underlies the economy at a macro level. The sooner the financial sector wakes up to the new paradigm of commodity scarcity and volatility that we have swan dived into, and the sooner we can endure the market ‘correction’ it causes, the sooner we can adapt.

Photo by iamwahid.