Expect financial fallout when the fossil fuel bubble finally bursts

Climate change — and the lack of timely, consistent action to address it — is driving the world toward a new financial crisis. Indeed, senior regulators are increasingly warning that this will cause a collapse similar to the 2008 Great Recession.

The head of the European Environment Agency recently warned that the European Union is at a “higher and higher” risk of systemic financial shock as the planet warms up. This follows similar alerts from U.S. Treasury Secretary Janet Yellen, President of the European Central Bank Christine Lagarde and Mark Carney, former governor of the Bank of England — as well as from financial experts at the London School of Economics’ Grantham Institute.

The danger is of a major “Minsky Moment” — a sudden and catastrophic plunge in asset values following a period of growth and stability. It takes its name from the economist Hyman Minsky, who understood that market optimism with inadequate regulation could push key assets like fossil fuels into a bubble of unjustified valuations. When these are corrected, investors would be stranded with insufficient returns, as we saw in 2008. 

The global financial sector will eventually face such a moment as its underlying assets — from all sectors, not just carbon-intensive ones — face both physical risks from climate impacts and transition risks as economies adjust to stronger climate constraints and as governments take more muscular action to speed the transition to clean energy needed to keep the planet safe from the most catastrophic impacts of climate change.

Carney, when he was head of the Bank of England, first warned of a “climate Minsky Moment” in a speech to the directors of Lloyd’s of London in 2015, and he has repeatedly done so since. The danger would arise, he said, unless there is a smooth energy transition, where the reassessment of fossil fuel energy asset values occurs gradually as clean energy replaces fossil fuels.

Yet over the ensuing decade, the fossil fuel industry has continued to delay the necessary energy transition and even convinced many people to falsely believe that climate change is not caused by burning fossil fuels.

Largely as a result, the world is on track for 2.5 to 2.9 degrees Celsius of warming (4.5 to 5.2 degrees Fahrenheit) — well past the 1.5 degrees Celsius (2.7 degrees Fahrenheit) guardrail. That’s the level at which warming will push the planet past self-reinforcing feedback loops and into tipping points with irreversible and catastrophic effects, which are projected to ultimately alter the climate so significantly it may no longer be habitable for life on Earth — including humans. There are signs this is already starting to happen.

The ongoing delay in a necessary transition away from fossil fuels means actions now must be accelerated. If we are to have a chance of staying relatively safe, fossil fuel emissions will have to be slashed by 43 percent by 2030 — threatening to strand significant investments. It also means that, if we are to have a chance of staying within sight of the 1.5 degrees Celsius guardrail, the fossil fuel industry must invest 50 percent of its annual capital expenditure in clean energy. Today, it invests an anemic 2.5 percent, while continuing to fund further exploration.

Already, the fingerprints of climate change are starting to emerge on the financial system, where increased volatility, capital shifts and, in extreme cases, capital flight can be connected to growing, but still underappreciated, climate-related financial risks.

Insurance is the canary in the coal mine. Insurance coverage for climate-related events, such as floods and fires, is increasingly becoming unaffordable, even unavailable, in regions such as Florida, the Gulf Coast, and California. As Warren Buffet just noted about his investments in some power utilities, this is a sign to avoid throwing good money after bad. In emerging markets, meanwhile, the escalation of extreme weather events is driving up the cost of capital, which is a central concern of the Bridgetown Initiative of Barbados Prime Minister Mia Mottley.

The value of key carbon-intensive assets will start to decrease, in some cases rapidly, as warming continues to accelerate. Increasingly devastating climate impacts will cause far greater financial losses. Insurance will continue to retreat, and climate regulations will tighten more rapidly.

These will be the combination of factors that cause the fossil bubble to burst, and it will affect everyone, not just fossil fuel investors, since uncovered risks will revert to the public balance sheet for all taxpayers to pay off.

All of these developments are happening now — not in some distant financial or climate future. We are past the point for the “smooth” and “gradual” transition that Carney urged a decade ago, making his warning of a major Minsky Moment even more relevant. Unlike the 2008 Wall Street bailout, it would be nearly impossible to bail out of a climate-driven Minsky Moment once feedbacks push us past tipping points, propelling runaway climate change and we lose control of the climate system.

Carney also understood that investors play an outsized role in addressing climate change because they decide whether their capital will help or hurt the cause. They must be informed about climate-related financial risks and overinflated valuations that fail to account for climate change. They can and should move fast once it is apparent that their financial returns are endangered, and that there are better opportunities in green investment. Barclays, for example, has just committed to finance $1 trillion in greener investments by 2030.

Like all economic transformations, this one will produce losers. Even pioneering climate-savvy investors need to watch for mini-Minsky Moments in which assets become uninsurable, then unviable, then crash. Yet addressing the climate crisis is a multi-trillion-dollar investment opportunity, and there will be more winners than losers in the net-zero climate-resilient transition.

Science-informed investors who race for the top should do everything they can to capture these opportunities and create market signals along the way for all industries. This will help protect investors and taxpayers in a time of volatility, accelerate the needed economic and energy transitions, and give us a better chance to restabilize the climate and financial systems before it’s too late.

Durwood Zaelke is president of the Institute for Governance and Sustainable Development and an adjunct professor at the University of California, Santa Barbara’s Bren School of Environmental Science and Management. Stacy A. Swann is founder and CEO of Resilient Earth Capital.