For resource-intensive economies, physical and transition risks could drive a ‘climate change risk trap’

On a global level, and in guidance for financial sector regulators, climate change actions are often presented as a sliding scale between climate mitigation – efforts to reduce emissions – and climate adaptation – efforts to make countries more resilient to the impacts of climate change.

The dichotomy arises within the financial sector through a similar sliding scale between different scenarios. Climate change impacts are presented as a choice between a slower transition resulting in higher physical risks such as floods, wildfires, droughts and sea level rise, and a faster transition resulting in greater economic dislocation associated with the climate transition.

Many OIC countries face a different outlook, however, where higher transition and physical risks coexist, especially at the sub-national level. A new paper terms this outcome a ‘climate change risk trap’, and evaluates it by considering the impacts of climate change physical and transition risks on Kuwait following the release of the country’s first flash flood hazard map.

The paper is focused on fossil fuel-exporting countries, which will be the most significantly impacted by the climate transition. But a similar challenge will face many OIC countries. Key characteristics for countries impacted by the climate change risk trap are those with higher physical risk vulnerability and economies that have experienced a delay in starting the climate transition.

These characteristics combine because many countries – particularly those that are more dependent on high emissions sectors – will find their physical and transition risk exposure to be determined globally, while the impact of both will be felt locally. The trap is created because the skills needed for the low-carbon economy are likely to differ from the skills present across the economy.

Retraining and reskilling – the essential pieces of a Just Transition – will help to reduce the impact. But for many countries, there will be a flow of workers within countries and also foreign workers bringing skills in short-supply towards locations where there are opportunities for the low-carbon economy. The movement of people following opportunities in the low-carbon economy, where it grows in places that face significant physical climate risks, will help overcome some of the transition risks, but often at the cost of exposing more people to climate-related hazards.

There is no simple solution to the climate change risk trap, especially with insufficient climate finance flows from high historical emitters to those most impacted by the consequences of those emissions. For governments, their second-best solution will be to pursue diversification away from transition-exposed sectors while pressing forward on faster climate action globally and increased climate finance flows, especially in support of Just Transition efforts and funds for adaptation through the Loss & Damage Fund.

For financial institutions in markets at risk of the climate change risk trap, there may be higher liquidity risks for institutions with significant cross-border funding sources. With the global financial regulatory bodies creating assessments of climate-related vulnerabilities that could affect financial stability, there is heightened risk of a ‘climate derisking’.

Financial institutions’ ability to withstand any future risks will be impacted by the speed at which they contribute to a Just Transition locally, improve their process for measuring, and take efforts to measure physical and transition risk. Financial stability risks related to over-dependence on external funding – particularly in foreign currencies – are not new, but like other climate-related financial risks, the risks may be novel but will impact financial institutions through familiar transmission channels.