N.B.: This article was first shared by Tim on LinkedIn
Regardless of the politics of the US’s latest excursion in the Middle East, continued disruption to the Straits of Hormuz threatens to have deep and lasting impacts on the global economy. The crisis has revealed in primary colours the vulnerabilities of our highly connected global economy.
To business leaders and boardrooms, it should serve as a prescient warning of our current inability to adapt to the environmental, commercial and socio-economic tail risks we might face in the near future. And yet, for now at least, the vast majority of climate risk assessments ignore these tail risks as if they didn’t even exist.
(For a quick but solid primer on the economic impacts of the US-Iran War, give Bryce Engelland’s piece for Thomson Reuters a read).
Why climate risk assessments ignore tail risks
Climate risk assessments rarely focus on deterministic scenarios, major tipping points or catastrophic tail risks.
The reason is frustratingly simple: climate tail risks are notoriously difficult to predict and their potential impact can be almost impossible to quantify. Put bluntly, they don’t fit neatly into a quantitative risk report. In fact, such catastrophic scenarios are often written off as black swans, the hidden risks that Donald Rumsfeld once referred to as “unknown unknowns”. But a lack of imagination is a very poor reason to ignore events that, while far from certain, could have potentially catastrophic consequences on individual businesses, entire industries or even the global economy.
For now, most climate risk analysis remains trapped in what Mark Cliffe calls “model land”. Many of our current models, including NGFS, imagine a world of tidy linear transitions and manageable temperature pathways that bear limited resemblance to what is actually happening to our planet. Iain Watt puts it even more starkly: “the failure to even consider tipping points, amongst a wider lack of appreciation of the uncertainties within climate projections, surely represents a failure at the first hurdle?”
A more realistic understanding of climate risk requires us to consider a series of tail risks and potential tipping points. Though complex, this is not impossible; it just requires a little imagination. Through considered simulation and planning, organisations can turn hidden risks into understandable scenarios, forming the basis for more complete risk analysis and mitigation.
Below I have outlined 5 climate shocks that organisations should consider stress-testing their strategies and business models against:
- Disruption to the Strait of Malacca
- Insurance market collapse
- Sovereign climate default
- Failure of the US Corn Belt
- Permafrost methane feedback loop
Please note: this list includes just 1 climate tipping point and several climate-related tail risks. I have barely scratched the surface in my analysis of each but I will be publishing further, more detailed articles on some of these in future: There are many others I could have included, but I hope the spread of economic, political and social scenarios will serve as a healthy starting point to begin looking beyond the steady, linear climate models that inform most climate risk assessments. West African cocoa farms. The highly interconnected nature of our food systems meant that these seemingly isolated issues cascaded into a nightmare scenario for some of the world’s biggest manufacturers: Hershey’s gross margins fell from 47% to 33%, Mondelez saw its earnings-per-share estimates slashed by double digits Nestlé’s leading brands had to quietly drop the word “chocolate” from some product labels as falling cocoa content breached legal thresholds.
Disruption to the Strait of Malacca
TL;DR: the Strait of Malacca carry even more oil than Hormuz, and are under significant threat from cyclones and burning of damaged peatlands. Major disruption to the Strait could cause a major fuel price spike, while also affecting supply chains to and from Northeast Asia.
Why does it matter ?
Roughly one third of global seaborne trade passes through the Strait of Malacca. This includes around 25-30% of global oil consumption, making it the single largest oil chokepoint in the world. It’s also critical for LNG flows, as well as commodities and consumer goods flowing to and from Northeast Asia.
Asia’s largest economies are particularly dependent on these Strait but the impact of major disruption on oil prices would have a global impact comparable to what we are witnessing as a result of the effective closure of the Strait of Hormuz.
While the impacts would be globally significant, companies with supply chains in Asia should be particularly wary of their exposure to a prolonged shutdown.
What’s the threat from climate change?
The waters feeding into the Strait – namely the Bay of Bengal and the South China Sea – are warming faster than global ocean averages. This is already intensifying cyclone and typhoon formation, a trend which will only intensify as the seas continue to warm. Such extreme weather could cause major damage to port infrastructure or force shipping to halt for a prolonged period.
Sumatra and Borneo’s vast peatlands, already degraded by land-use change and drying, produce catastrophic smoke hazes. In 2015 and 2019, visibility in the Strait fell to near-zero for extended periods, disrupting the flow of goods. Such incidents are likely to become more frequent as dry periods are extended, and the peatlands continue to be depleted.
It’s also worth bearing in mind that the closest suitable alternative route is through the Lombok Strait, adding 1,000 nautical miles to the journey, increasing fuel costs and time.
Insurance market collapse
TL;DR: the insurance industry is vital to the functioning of the global economy and is already under significant strain as a result of climate change. Even a partial failure could have ramifications for almost every industry in the world.
Why does it matter?
Insurance is the load-bearing wall of the global economy and the bedrock of capitalism. By diversifying and managing risk, it enables the most fundamental facets of our economy. It also controls one of the most significant pools of institutional capital, with systemically important investments across virtually every market on earth. It should therefore be a source of the most pressing alarm that this vital industry could be brought to its knees by climate change.
I could (and will) write an entire article on the threats to the insurance industry and their potential ramifications, but for now let’s just consider a couple of the biggest threats to the industry and the potential impacts of failure:
Home insurance
In coastal areas of the US – most notably Florida and California – major home insurance carriers are already exiting the market. The risks to homes from fires, hurricanes and coastal flooding mean that home insurance is simply unviable across large areas. While the State has stepped in as the insurer of last resort, it is dangerously undercapitalised and ill-prepared to deal with another major climate event.
Areas like these are the canaries in the coalmine; huge swathes of the world’s housing stock could become uninsurable in the coming years. Without insurance, banks will not offer mortgages, and the value of houses will drop like a stone. Given how much of the global economy relies on house price stability, this is as dangerous for the global economy as it is for the people living in these areas.
Cargo insurance and global supply chains
Cargo insurance underpins global trade and supply chains. As we have seen during the current crisis in the Strait of Hormuz, firms are simply unwilling to offer insurance – not just because of what is actually taking place on the ground, but because of the ongoing uncertainty and increase in perceived risk. Without this insurance, trade grinds rapidly to a halt. As more and more places become threatened by the impacts of climate change, the percentage of global trade that becomes uninsurable will only increase.
Forced liquidation and systemic threats
The global insurance industry’s assets under management are estimated to be more than $40 trillion, or more than 40% of global GDP. Due to years of otherwise sensible investment strategies, they are now heavily exposed to the mortgage, real estate and infrastructure industries – precisely the asset classes most exposed to climate-related risks. A series of major climate events could force liquidation of assets to meet claims, resulting in a dangerous selling dynamic which will spark memories of the 2008 global financial crisis.
Sovereign climate default
TL;DR: in many vital economic centres, sovereign defaults will be made more likely by climate change. Depending on your business’ particular supply chains and dependencies, such failures could have enormous ramifications. How the international community handles such crises could determine how far the ripples will spread.
Many of the most debt-ridden economies in the world are also at the most significant risk from the chronic effects of climate change, as well as increasingly frequent and intense climate hazards. This raises the very real possibility of a large, emerging economy defaulting on their sovereign debt as a result of climate change, with cascading effects arounds the world.
Indonesia – catastrophic deforestation and peatland degradation are causing havoc within the country, with the capital city already being relocated due to subsidence and flooding. Coupled with the country’s enormous coal export revenues, which are likely to become less desirable in future, the structural risk to Indonesia’s economy is enormous. Given the country’s size and importance to manufacturing supply chains in Asia, a climate-compounded fiscal crisis here would have global ramifications
Pakistan – agricultural collapse is a very real possibility under certain climate scenarios. While the primary impact would be to food security across the region, a broader economic and political collapse of a nuclear state could have wider geopolitical ramifications, especially given long-standing and ongoing tensions with close neighbours
Egypt – flow reduction or even failure of the Nile, for which more than 250 million people are reliant for water, could result in a climate-compounded fiscal collapse. Aside from the mass migration of affected people, the impact on trade through the Suez Canal would also have wide economic implications.
Nigeria – advancing desertification, coupled with widespread flooding in the Niger Delta could put major strain on Africa’s largest economy. The country’s economy is also highly reliant on oil revenue, creating a heightened risk of major assets becoming stranded in a lower-carbon global economy. A failure to service Nigeria’s debt also risks chilling climate-related lending across the continent, at precisely the moment it is most needed.
Failure of the US Corn Belt
TL;DR: The prosperity of agricultural breadbaskets, like the US Corn Belt, affects far more than just commodity prices. Whether your supply chains lie in agriculture or pharmaceuticals, or just require cardboard packaging, a significant failure in the Corn Belt could have major consequences. And that’s not to mention the political instability that might follow.
Why does it matter?
Known as the Corn Belt, the US Midwest is one of the world’s great breadbaskets. It produces a third of global maize exports and a quarter of global soybean exports, in addition to significant wheat and pork production. No other single growing region on earth comes close for its financial and systemic impact.
A structural impairment across the Corn Belt would have dire consequences for food security, economic prosperity and, ultimately, political stability. The first and most obvious impact would be a spike in food prices, firstly of maize and soybeans themselves, but quickly of the protein sources (chicken, pork, beef and fish) that rely on these crops for feed. Such a price spike would be followed, quickly and inevitably, by the detonation of some of the world’s largest commodity derivatives markets.
Nearly 40% of US corn goes into domestic ethanol production, so crop failure would also spike gasoline prices and destabilise global agricultural markets, particularly for biofuel producing countries like Brazil whose own pricing is benchmarked against US corn ethanol.
Processed food manufacturers and fermentation-based pharmaceutical producers, reliant on cheap corn derivatives, would be next to wave the white flag. Meanwhile, paper and cardboard packaging, reliant on corn-starch as a binding agent, would increase prices across almost every supply chain.
The desperation of agricultural lenders would be matched only by governments scrambling to reprice the sovereign debt of food-importing nations across the Middle East, North and Sub-Saharan Africa. In those regions where food costs represent a large share of household income, political stability is tied closely to food prices, as anyone with a memory of the Arab Spring will know all too well.
What’s the threat from climate change?
For decades, the pressures of modern agricultural systems have undermined the physical and hydrological systems of the Corn Belt. As climatic stresses increase, the combination increases the risk of crop failure significantly.
Corn is surprisingly sensitive to temperature at very specific moments in its growth cycle. For example, if temperatures climb above 35°C (95°F) during the plant’s short pollination window, pollen viability and yields fall sharply. Climate change is increasing the duration and intensity of periods of high temperature, increasing the risk of passing this vital threshold.
Rainfall patterns are also a major concern. As in many places, rainfall is becoming less frequent but more intense, causing runoff and soil erosion. The Corn Belt has traditionally had some of the deepest, richest topsoil anywhere on earth, but the degradation of the prairie ecosystem, compaction from heavy machinery and increased erosion has already reduced carbon in the topsoil by 35%.
The intervals between rain are also becoming longer and drier, increasing the frequency of drought. Events like the 2012 drought, which caused an estimated $30 billion loss in agricultural output, are likely to become much more frequent. These drought conditions are even more alarming given the state of the Ogallala Aquifer, on which the entire growing region relies. In some areas, half of the aquifer volume has already been depleted and irrigation is only likely to increase as higher temperatures increase crop water demand.
Permafrost methane feedback loop
TL;DR: The permafrost is an almost unimaginably massive store of organic carbon at the top of our planet. If a sustained acceleration in Arctic methane emissions were to take hold, the impact on our climate could be civilisational in scale. But the most immediate impact would be an immediate revision the planet’s carbon budget. Every climate target, green bond and sustainability regulation would become materially insufficient overnight. Expect fragmentation of climate policy, threats of litigation and even further growth in the suspicion of climate science.
What even is the permafrost?
Locked in frozen soils across Siberia, Alaska, Canada and the Tibetan Plateau, the permafrost contains an estimated 1.5 trillion tonnes of organic carbon, enough to produce roughly 5.5 trillion tonnes of CO2. That’s about the same as the entire global forest system and all of the world’s proven fossil fuel reserves combined.
By comparison, Earth’s entire atmosphere currently contains approximately 860 billion tonnes of CO2, so the permafrost alone contains enough carbon to produce roughly 6 times the CO2 in our entire atmosphere if it were to be released. The reality is even more alarming: much of the permafrost carbon is actually converted to methane (CH4) when released, rather than carbon dioxide (CO2). Methane has a substantially higher global warming potential carbon dioxide, turning the release of the permafrost into a truly cataclysmic proposition.
The permafrost is already melting, with Arctic temperature rising at 3-4 times the global average rate. However, we have not yet reached the tipping point at which the melt becomes entirely self-reinforcing. There is still a human off-switch, but there might not be for long.
So what happens if the feedback loop begins?
If a permafrost methane feedback loop really takes hold, the carbon budget modelled by the IPCC will be revised sharply downwards. Effectively, that means that every assumption about the levels of emissions reductions we need to make to limit global warming become completely insufficient.
Every net-zero target becomes redundant. Every sustainability-linked bond becomes junk. Every investment justified by a specific carbon pathway assumption turns bad. The market for carbon offsets and credits would implode. Climate-related insurances would be repriced or withdrawn overnight.
And then would come the politics.
Some jurisdictions might respond by tightening policy dramatically, accelerating fossil fuel phase-out and imposing aggressive carbon pricing. Others would argue the scientists clearly don’t know what they’re talking about, and continue down the road of denials and delays that are the marker of so much of today’s climate policy. Amongst the general public, many more would become entirely apathetic, conceding defeat to the inevitability of climate Armageddon.
Some would even see a silver lining of new shipping routes and opportunities for resource extraction, triggering a wave of territorial disputes. Greenland would be only the beginning.
Is there any point planning for such a cataclysm?
This scenario is a transition planning nightmare. It forces businesses to confront a risk that sits entirely outside current scenario-planning architecture. It is virtually impossible to model, to price or to hedge. It would therefore be a legitimate challenge to ask whether there is even any point in stress-testing a scenario that represents an existential threat to civilisation itself.
But here’s why it still matters: even the most destabilising scenario has a reasonably long period of transition. An organisation that has stress-tested that transition to multiple plausible planetary futures, however bleak, will be in a fundamentally better position to one that hasn’t. Any organisation that has understood and internalised a catastrophic scenario will be in a stronger position to make different and better decisions about capital allocation, long-term debt and lobby priorities. The point is not to have a plan for 2080, but to make better decisions today.
Ultimately, the willingness and ability to plan and stress-test against this sort of scenario is what defines the kind of organisation you are. As an organisation, do you look clearly at the worst plausible outcomes and let them shape your behaviour, or just look away because the view is uncomfortable? In a world where the permafrost feedback scenario is a very real and live scientific possibility, that choice is both a moral and strategic statement.
What’s your view? What climate shocks should businesses consider in their scenario planning? Is there even any point considering the most cataclysmic scenarios? Share your thoughts in the comments.
At Sirocco, we work with companies to understand climate-related risks beyond the obvious. If you’re starting to think seriously about what the climate means for your business, or want to understand what UK SRS could mean for you, we’re always glad to have that conversation – just drop us a message.
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