16.02.2024
The economic and financial implications of climate change
Club Última Hora - Cercle D'Economia de Mallorca
Palma de Mallorca
Pablo Hernández de Cos
Governor
1 Introduction
Ladies and gentlemen, let me begin by thanking Carmen Serra, Chair of the Serra Group,
and José María Vicens, Chair of the Cercle d'Economia de Mallorca, for their kind invitation
to speak at this conference at the Club Última Hora. I also wish to thank professor and
Council Member of the Banco de España Carles Manera for helping to make this meeting
possible.
We are here today to discuss one of the greatest challenges facing our society: climate
change and the transition to a low-carbon economy.
From an economic standpoint, the consensus among researchers is that if we fail to
significantly reduce greenhouse gas (GHG) emissions in the coming decades, the impact of
the physical risks associated with global warming will be very significant. At the same time,
the transition to a low-carbon economy also poses transition risks arising from the need to
adapt the productive model.
In this setting it is imperative that public policies actively contribute to the green transition.
Governments, in particular, have a key role to play in this process. They have the necessary
democratic legitimacy to define a roadmap and the best toolbox to achieve the proposed
targets, especially through fiscal and regulatory policies.
But climate change and the transition to a low-carbon economy also pose a major challenge
for central banks, as they could significantly affect both economic activity and price and
financial stability.
In my address today I will first focus on illustrating how the materialisation of some of the
physical risks associated with climate change could affect the economic and financial
situation. I will then show how ambitious, timely, orderly and predictable mitigation policies
are our best option to tackle climate change, not only from an environmental standpoint,
but also from an economic one.
2 The economic implications of physical risks
The regular reports of the Intergovernmental Panel on Climate Change (IPCC) warn that,
1
unless GHG emissions are significantly reduced, global warming will continue. Numerous
studies show that in the coming years global warming will cause, among other disruptive
phenomena, a rise in sea levels, progressive soil desertification, an increase in the frequency
and intensity of extreme weather events and a very significant loss of biodiversity.
Despite the uncertainty in quantifying the physical risks associated with climate change and
their economic impact, the consensus is that the Iberian Peninsula will be particularly
affected.
By way of illustration, the exercises carried out by the Network for Greening the Financial
System (NGFS)2 indicate that Spain would suffer a substantial economic decline if these
risks were to materialise in the coming decades (both those associated with chronic
phenomena - higher temperatures, desertification and rising sea levels - and those
associated with severe or extreme weather events such as floods, storms or wildfires).
These risks can materialise through various channels. They can affect the supply side of the
economy by disrupting production processes, damaging physical capital, reducing
productivity and increasing mortality. Meanwhile, demand would also be affected by the
negative effects of climate events on wealth and uncertainty, which would affect the
consumption and investment decisions of households and companies. These processes
would also have an impact on financial stability, as they would entail adjustments in the
financial position of households and firms and affect their ability to meet their payment
commitments.
I will now summarise the results of various Banco de España papers that have examined
some of the economic implications of several of the physical risks mentioned.
First, we studied the physical risks associated with rising temperatures. In particular, the
Banco de España has analysed the macroeconomic and financial impact of droughts and
3
severe heatwaves in Spain, since our country is particularly prone to these events.
This exercise4 shows that, in the year following a drought or a severe heatwave, there is a
marked slowdown in economic growth and a rise in inflation, accompanied by a fall in
housing prices.5 In particular, the one-year impact on real GDP growth of this scenario would
be as large as -1.3 percentage points (pp), and it would be accompanied by a decrease of
4.2% in house prices and a 1.5 pp rise in inflation with respect to the baseline scenario, in
which the drought and heatwave episode does not occur.
In any event, the economic impact is heterogeneous by sector and mainly depends on each
sector's exposure to weather conditions. The most affected sectors in terms of gross value
added would be construction, mining and quarrying, forestry and fishing, and
transportrelated sectors.
The financial sector is highly exposed to climate change risks as it finances other sectors,
including those exposed to extreme weather events or that are not necessarily
environmentally friendly. In fact, in the previous simulation, the negative impact on activity
and house prices would also result in a slight reduction in banks' solvency ratios.
In particular, the materialisation of severe droughts and heatwaves would lead to a 0.2 pp
reduction in the CET1 ratio of Spanish institutions. Most of this impact would persist over a
three-year horizon. Bank capital consumption in this adverse scenario is mainly explained
by higher impairment losses and lower net income generation, in line with lower economic
activity.
The banking sector would probably react by deleveraging, which would mitigate part of the
impact on solvency that I just mentioned, but exacerbate the macroeconomic impact. In any
event, if droughts and heatwaves were to become recurrent, their negative impact on the
solvency and profitability of the banking sector would be greater than the short-term effects
identified in this analysis. Also, heatwaves and droughts can occur simultaneously in several
countries, posing additional risks.
Second, we analysed the risks of desertification, defined as the process of land
degradation in arid, semi-arid, and dry sub-humid areas resulting from various factors,
including climatic variations and human activities. Once again, Spain is one of the European
countries most vulnerable to this phenomenon, as almost three quarters of its territory are
drylands that are prone to desertification.6
Naturally, desertification can have substantial economic and financial consequences.
Empirical evidence shows that its chronic nature can lead, for example, to out-migration
from the affected areas, among other socio-economic changes. In turn, these effects could
have an indirect impact on banks by affecting economic growth and, ultimately, borrowers'
creditworthiness.7
For instance, in a forthcoming Banco de España working paper, Broto and Hubert (2024)
analyse the extent to which the desertification process affects lending to Spanish
nonfinancial corporations, in an initial attempt to gauge its impact on economic growth and
employment.8 The main explanatory variable in this research is an aridity index, which
correlates positively with temperature and negatively with rainfall and which has
deteriorated across almost the entire country in recent decades.
This deterioration nonetheless varies considerably from region to region. On the one hand,
20% of the Spanish territory classed as dry (sub-humid) in the 1970s is now considered
semi-arid, i.e. it has become more arid. Meanwhile, the humid northern regions of the Iberian
Peninsula have also become increasingly arid. On the other hand, certain areas in the vicinity
of the Pyrenees or the Ebro Delta have lower aridity levels than was previously the case.
The key takeaways from this research into the correlation between lending to non-financial
corporations and aridity are as follows.
First, greater aridity is associated with a lower volume of lending to non-financial
corporations, particularly over longer time horizons. Specifically, a 1 pp increase in the
aridity index is associated with a 20 basis point (bp) fall in the volume of long-term lending.
Nonetheless, it takes between 10 and 15 years before this effect becomes statistically
significant.
Second, the impact of aridity on lending varies by sector. Agriculture is without doubt the
hardest hit, with lending to this sector falling by around 25 bp over a 20-year period after a
1 pp increase in the aridity index. Conversely, overall the Spanish tourism sector has proven
relatively impervious to aridity, having managed to adapt to the effects of higher
temperatures and less rainfall.
In any event, we should be wary of extrapolating these findings to the future, since adverse
non-linear effects could emerge if the desertification process continues and certain aridity
thresholds are breached.
Third, wildfires could also become increasingly commonplace as a result of climate
change, triggering financial losses, for example via the cost of collateral and lending to the
private sector. Indeed, recent years have seen an increase in both the frequency and the
severity of wildfires,9 with Spain among Europe's worst affected countries.10 For instance, it
accounted for around 40% of the EU land ravaged by forest fires in 2022.
A recent Banco de España paper11 looks at how wildfires impact bank lending to affected
firms. Specifically, such lending declines by around 6% compared with the credit extended
to similar unaffected firms.
Moreover, the analysis reveals that, in a context of asymmetric information, local banks (i.e.
those whose lending is concentrated in a particular province) play a pivotal role in mitigating
the impact of fires on economic activity, using their superior qualitative data to lend to
profitable firms affected by the fires.12 As a result, it is found that, two years after a fire,
employment falls by around 2% when there are no local banks operating in a fire-hit region,
whereas it remains unchanged when local institutions take an active role in lending.
Fourth, flooding is another type of extreme weather event that can pose physical risks.
According to a granular analysis13 conducted by the Banco de España, 1.3% of the
residential properties used as mortgage collateral in Spain are located in areas at risk of
flooding within the next 10 years. Over longer time horizons (50 and 500 years), this
proportion rises to 2.7% and 7.7%, respectively.14 Overall, this analysis therefore suggests
that the banking sector's mortgage portfolio currently has limited exposure to flood risks.
However, the frequency of such events and the size of flood-prone areas could increase in
the future if nothing is done to prevent climate change. In any event, further work is needed
to improve the available databases and to continue researching, inter alia, the extent to
which property appraisals already capture flood risks or if, alternatively, there is a risk that
appraisal values might suddenly change were such events to occur, and the role of insurers.
Fifth, severe environmental degradation can also have adverse economic and financial
impacts through various channels, including, again, the value of real estate collateral.
We already have evidence of these kinds of effects in Spain. A case in point is the Mar
Menor, the largest salt-water lagoon in Europe, on the South-Eastern coast of Spain, in the
region of Murcia. The Mar Menor is also a major tourist hotspot, with 7,500 beds in the
surrounding area and annual visitor numbers historically exceeding the 200,000-mark.
However, since the 1960s the Mar Menor ecosystem has come under increasing strain with
the growth of agriculture and tourism. This ecological degradation is primarily the result of
the expansion of the agricultural sector and agri-food industry in the vicinity of the lagoon,
particularly since the shift from dry-farming to irrigated crops (now accounting for more than
80% of the total area).
This deteriorated environment, combined with frequent climate change-related flooding and
extreme temperatures in the region (as high as 47°C in August 2021), has been a key factor
behind the changes in the nitrogen and phosphorus nutrient cycles, leading to
eutrophication (i.e. an increase in biomass in a body of water), and the widespread growth
of algal blooms in particular. This massive expansion of algae (dubbed the "green soup")
meant that light can no longer reach the bottom of the lagoon. The plants on the lake bed
die off, leading to an increase in decomposition caused by bacteria, which use up the
available oxygen, thus killing the fish.
A Banco de España paper by Lamas et al. (2023)15 shows that property prices in the
surrounding areas took a sizeable hit once the locals realised the scale of the environmental
damage in the Mar Menor. This realisation, which dawned some time after the actual
damage had been done, was borne out by an increase in the number of negative tweets
since 2015, as well as in the number of negative news reports on the Mar Menor.
The return on housing investment was 43 % lower in the surroundings of Mar Menor than
in comparable neighbouring zones in the period 2015-2021, a period comprising six years
after the moment in which the lagoon began to reflect the impact of the degradation of the
ecosystem. This negative return differential represents a total loss in housing wealth of more
than 4 billion euros, around ten times the gains from the very change from dry-farming to
irrigated crops which made this ecosystem fragile in the first place.
As a result, the return on housing investment was 43% lower in the surroundings of the Mar
Menor than in comparable neighbouring areas between 2015 and 2021, a six-year period
after the moment in which the lagoon began to reflect the impact of the ecosystem's
degradation. This negative return differential represents a total loss in housing wealth of
more than €4 billion, around ten times the gains from the very change from dry-farming to
irrigated crops which made this ecosystem fragile in the first place.
The authors also show that the median mortgage principal in the control area has risen by
more than 40%, while remaining unchanged in the Mar Menor area, suggesting that banks
have incorporated lower housing values into their lending decisions.
Also, the number of house purchases, which was similar in both areas prior to 2015, has
almost doubled since in the control area relative to the area around the Mar Menor, reflecting
the weaker performance of the latter's economy.
The analysis suggests that house buyers and property investors did not account for
climaterelated risks and their impact on the lagoon. It is only when these risks materialise and the
public becomes aware of them that climate-sensitive assets, such as real estate, undergo
a shift in prices
3 The economic implications of transition risks
According to the NGFS simulations that I mentioned at the beginning of my speech, the
implementation of policies to achieve an energy transition that would cut net CO 2
emissions to zero by 2050 - not only by means of strict climate policy, but also by boosting
innovation - would significantly reduce the economic costs associated with the
extreme and chronic physical risks that we face if we do nothing.
However, the transformation towards a low-carbon economy may cause attendant
transition risks to arise as a result of mitigation initiatives that the authorities have already
implemented and the need to adapt economic activity.
Ultimately, the world must reduce the use of fossil fuels and adopt cleaner technologies to
cut GHG emissions. To do this, governments are taking measures to increase the implicit
cost of GHG emissions by raising carbon prices - whether via carbon taxes or auctions of
emissions allowances - and imposing regulatory standards that penalise the use of polluting
(brown) technologies and/or bolstering public and private investment in green technologies.
In some cases, these actions can have adverse effects on households' purchasing power,
firms' profitability, the stability of financial markets and government deficits. Furthermore,
the uncertainty surrounding the scale and the speed of implementation of these public
policies can negatively affect the decisions of economic agents.
The Banco de España has developed several macroeconomic models16 to analyse these
impacts. They are general equilibrium models with a highly granular sectoral structure that
capture, in considerable detail, the use of different types of energy in production and
consumption and in which GHG emissions occur as a result of energy use. These models
have been used to simulate rising carbon prices, for example, and reveal the costs of the
transition in terms of lower GDP, consumption and employment.
Nevertheless, it was also found that properly designing measures to combat climate
change can significantly reduce the scale of these transition risks and, in
consequence, their macroeconomic impact. For example, the adverse effect on
households' purchasing power can be lessened if the revenue obtained via a carbon tax or
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auctions of emissions allowances is used to reduce other distortionary taxes.
In any event, there is also evidence of potential harm to some sectors even with the use of
policies aimed at avoiding substantial aggregate transition costs, such as in the case of the
agriculture, fishing, transportation and energy sectors. It is worth noting that the sectors
most affected are not only those directly affected by mitigation policies (such as those that
currently fall under the EU's Emissions Trading System, e.g. paper production, or those that
will do so under future expansions, e.g. shipping), but also those with strong ties to such
sectors, e.g. the forestry, logging and publishing industries.
These findings show that climate change and the transition to a more sustainable economy
will have highly heterogeneous effects across regions, sectors, firms and households. In
fact, such processes are likely to have a notably adverse impact on certain groups of firms
and households that are particularly vulnerable, among other reasons because such groups
will be relatively harder hit by any increase in green taxes owing to their consumption and
production patterns.
Using some of the tax revenue gained from policies to combat climate change to
compensate those most harmed by that process and helping them to adapt will be
key to minimising the transition costs and guaranteeing public support.
The probability of these transition risks materialising in the future and to what degree they
do so will depend on the swiftness with which the transition to a low-carbon economy is
implemented. Specifically, an orderly (as opposed to disorderly) transition will limit transition
risks.
In effect, any delay in the transition could increase the need to implement it more abruptly
in the future. This could trigger sharp relative price adjustments and a marked deterioration
in the financial position of households and firms, adversely affecting financial stability, which
would magnify the negative impacts on the real economy.
Indeed, stress test analysis shows that the banking system's solvency can be significantly
eroded under such disorderly transition scenarios. For example, the Banco de España's
estimates18 show that, under those circumstances, the aggregate CET1 ratio of Spanish
banks would fall by 1.2 pp in three years relative to the baseline scenario. In this scenario,
accelerated transition measures are only applied after 2030 to compensate for the previous
period of inaction, leading to abrupt and marked increases in the prices of fossil fuels in an
environment in which economic agents have limited access to low emission technologies
and their incomes and activity are negatively affected.
By contrast, a scenario in which measures to combat climate change are implemented
in a timely and gradual fashion limits their adverse economic and financial impact. For
example, the estimated impact on the aggregate CET1 ratio under such an orderly transition
scenario would be just -0.15 pp over a three-year horizon.19
It should be noted that incentivising investment in renewable energies is one of the most
important channels by which early mitigation policies can significantly lessen transition risks.
This is the case because many of the investments needed for adaptation (investment in
renewables, improvements in energy efficiency and electrification, for example) have long
maturity periods.
These findings help to highlight the importance of the credibility and certainty of
environmental policies in minimising the short-term economic costs of transition
policies.
4 Final remarks
Allow me to close with three main points.
First, the economic analysis available reveals the high economic costs that would be
entailed by failing to correct the current path of GHG emissions.
Second, it underlines the fact that delaying actions means an increase in both environmental
and transition costs. Therefore, we must adopt a mitigation strategy that is ambitious,
timely, orderly and predictable to address climate change. This strategy should also
be global to be effective
Third, climate change and the transition to a more sustainable economy will have
highly heterogeneous effects across regions, sectors, firms and households and may have
a particularly adverse impact on the most vulnerable. In consequence, particular care must
be taken to temper distributional effects. Otherwise, the economic costs of the green
transition may not only be higher, but incidents of social unrest may hinder the speed and
ambition of the process.