Should we be bracing for a transition-related financial crisis?

As the clock ticks down from the 2015 Paris Agreement, there is growing uncertainty that on our current trajectory the world is going to meet the stated goal to be net-zero by 2050. As this target approaches and governments around the world come under increasing pressure to implement policy and other measures to reach it, the likelihood of a smooth, orderly transition to a low-carbon economy diminishes. Experience tells us that financial markets rarely react well to sudden shocks or forced changes.

Losses from stranded fossil fuel assets could result in a US$2.5 trillion loss in financial wealth. This represents some 2.5% of global stock market capitalization. While this may not seem a significant figure, it is worth bearing in mind that subprime mortgages that started the 2008 Global Financial Crisis were worth less than US$ 0.5trillion.

Potential catalysts for a net-zero financial crisis

Identifying trigger points for such events ahead of time is inherently difficult, but there are a couple coming up that warrant further attention as they have the potential to catalyze a financial crisis. The submission of new nationally determined contributions (NDCs) by countries in time for COP30 next year is one and the forthcoming interim review of decarbonization targets by some of the major investor groups, such as Net Zero Asset Owner Alliance, is another.

Will a forecast overshoot drive more ambitious NDC targets and concrete policy action?

A key component of the Paris Agreement, NDCs are submitted every five years. They outline each signatory country’s plans to decarbonize their respective economies including a set of intermediate targets and the steps to reach net-zero, which include the all-important policy action required to enforce compliance. The intention is that targets become more ambitious each time they are submitted. The problem with the current set of NDCs is that they are not ambitious enough to limit global warming to below 1.5°C or even 2°C by 2100 and the current policy framework isn’t adequate to enforce them. According to the latest Carbon Action Tracker report, under the current NDCs a temperature increase of 2.5°C by the end of the century is considered most likely with 2.1°C regarded as being an optimistic outcome if all current and long-term commitments are adhered to. This forecast overshoot of the 2100 goal is likely to mount further pressure on governments to make next year’s revised set of NDC targets even more ambitious and include more concrete policy action. On their own, increased targets are unlikely to set off a financial crisis; however, if they are backed up with stricter policy initiatives, this combination could be enough to initiate a market sell-off in carbon intensive assets, such as fossil fuel stocks. Such a selloff has the potential to trigger broader contagion across all asset classes and ultimately a financial crisis as liquidity dries up and investors rush to re-balance their portfolios.

A recipe for a disorderly net-zero transition

A rapid and disorderly sell-off of carbon-intensive stocks would inevitably result in a revaluation of fossil fuel assets, which would lead to a stranding of assets and financial losses for investors heavily exposed to carbon-intensive industries. It is also highly likely to cause a greater knock-on effect leading to increased market volatility, affecting not only the energy sector but global financial stability more broadly. The disorderly nature of this sell-off could exacerbate market uncertainties, potentially leading to abrupt price fluctuations and liquidity challenges across asset classes and sectors. It may also raise concerns about the resilience of financial institutions with significant exposure to fossil fuel assets.

The coinciding reviews from investor alliance groups

The risk is further compounded by the upcoming review of interim targets that members of the major investor alliance groups had set themselves to reach by 2025. Controlling tens of trillions in investments, the economic muscle of the net-zero investor groups – such as the UN-convened Net Zero Asset Owner Alliance and the Net Zero Asset Managers initiative – matters a lot. These groups are due to review their progress against net zero targets in 2025. The question is what they do after that. Will they just set more ambitious targets for 2030 and do nothing else or will they set more ambitious targets and start to adjust investment portfolios? If they do the latter, this could lead to a large sell-off of carbon intensive assets. It is important to note that the impact of the next round of NDCs and the decisions made by the investor alliance groups are not mutually exclusive of each other. Either group is capable of provoking a financial crisis.

Could physical climate risks indirectly influence outcomes?

While it is still too early to determine to what extent the NDCs, particularly those of the major industrial economies, will be revised – this being largely dependent on the outcomes of elections in the US, UK and EU happening later this year – an expected spike in extreme weather exacerbated by the current El Niño event could prove influential to these deliberations. The global 1.5°C temperature spike anomaly is expected to cause an increased number of extreme weather events in 2024, leading to a 0.25% lower GDP over the next two years. Academic studies have found that societies become much more willing to invest in decarbonization when they have first hand experience of the effects of global warming on their economies and way of life. For example, a cluster of significant physical events that lead to mass casualties or large financial losses could lead to more willingness and pressure from society at large to decarbonize.

Pragmatic financial institutions should start to prepare now with climate scenario analysis

So, for the moment, all eyes are on these two important groups as we attempt to understand whether the world is about to embark on an orderly or disorderly transition. In the meantime, investors need to better understand the implications of a range of possible climate change scenarios on the assets in their investment portfolios. The longer they leave this, the greater the risk of being unprepared for a disorderly transition and the ensuing financial crisis.