The huge strain caused by the climate crisis could cause an economic recession “the likes of which we’ve never seen before,” a US study has warned. 

The increase in prevalence of extreme weather, bringing deadly heatwaves, more severe storms, and causing wildfires and floods, is insufficiently accounted for in financial markets, raising the possibility of a sudden correction when serious problems arise, according to new research from University of California.

“If the market doesn’t do a better job of accounting for climate, we could have a recession – the likes of which we’ve never seen before,” said Paul Griffin, an accounting professor at the UC Davis Graduate School of Management.

The research found there was an overabundance of “unpriced risk” in the energy market – representing a failure to take into account factors which could have significant impacts on the future value of a business.

In the US, this is because oil refining operations on the Gulf Coast are exposed to the threat of storms and sea-level rise, while other oil refineries in Northern California are exposed to coastal flooding.

Exposure to such risks can be reduced by taking out suitable insurance policies, but as the various hazards posed by climate breakdown are rapidly intensifying, it is not clear insurance companies will have the capacity to fill the gap, the research suggests.

“Unpriced risk was the main cause of the Great Recession in 2007-2008,” Professor Griffin said. 

“Right now, energy companies shoulder much of that risk. The market needs to better assess risk, and factor a risk of extreme weather into securities prices,” he said.

The research linked the excessive high temperatures, like those experienced in the US and Europe in summer 2019, with a swathe of economic impacts.

Such heatwaves can be deadly, can disrupt agriculture, can harm human health and stunt economic growth. 

They also can overwhelm and shut down vast parts of vital energy infrastructure. This was the case in northern California when Pacific Gas & Electric shut down delivery during fires and weather that could trigger fire.

Energy companies’ transmission infrastructure is often located in arid areas, increasing risk of damage, such as the destruction caused by wildfires in California.

Water delivery and transportation routes and services are also threatened by extreme weather, which then impact businesses, families, entire cities and regions – sometimes permanently, the study said. All of this strains local, and eventually, broader economies.

“Despite these obvious risks, investors and asset managers have been conspicuously slow to connect physical climate risk to company market valuations,” Professor Griffin said.

“Loss of property is what grabs all the headlines, but how are businesses coping? Threats to businesses could disrupt the entire economic system.”

In addition to the uncertainties over the level of cover insurers can offer, Professor Griffin said, “litigation, sanctions and even loss of business from the property destroyed”, should all also be considered risks in relation to the changing climate.

“The climate litigation risk already priced into energy stocks (after, for example, a protracted ExxonMobil court case in the 1990s) would prove insufficient,” he said.

“While proprietary climate risk models may help some firms and organisations better understand future conditions attributable to climate change, extreme weather risk is still highly problematic from a risk estimation standpoint.

“This is because with climate change, the patterns of the past are no guide to the future, whether it be one year, five years or 20 years out. Investors may also normalise extreme weather impacts over time, discounting their future importance.”

The paper “Energy Finance Must Account for Extreme Weather Risk” is published in the journal Nature Energy.

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