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Taking climate risk seriously
Social and economic costs of failing to prepare for climate change risks too high to ignore
6 Jul 2020 | Hauke Engel and Mekala Krishnan

Covid-19 has shown how a long-recognized but underappreciated global risk can suddenly materialize and wreak social and economic devastation in a matter of weeks. The implication is clear: While the world is rightly focused on battling the current pandemic, firms and governments must also recognize and plan for other risks, particularly climate change, which, like a pandemic, could upend the global economy if not managed properly.

That is not a conclusion we arrive at lightly. At the McKinsey Global Institute, we spent a year assessing the possible socioeconomic impacts of climate change over the coming three decades. What we found is that these effects already exist and are increasing, often in non-linear ways. As part of our analysis, we conducted nine case studies across regions to gauge potential effects, linking climate models with economic projections in each case. We estimated inherent physical risk – absent climate adaptation and mitigation – to assess the size of the challenge and highlight the case for action.

Climate researchers frequently use representative concentration pathway (RCP) scenarios, ranging from lower (RCP 2.6) to higher (RCP 8.5) atmospheric carbon dioxide concentrations. We adopted the higher-emission RCP 8.5 scenario in to assess inherent physical risk in the absence of further decarbonization.

Our case studies produced several key findings. First, the most at-risk societies and systems are already close to physical and biological thresholds. Moreover, increasing climate hazards may make such systems vulnerable when they reach such thresholds, often resulting in non-linear intensification of effects.

For example, increasing heat and humidity in India mean that by 2030, and under an RCP 8.5 scenario, between 160 million and 200 million people could live in regions with a 5% average annual probability of lethal heatwaves. As heat and humidity levels rise, outdoor work could become extremely challenging. We estimate that by 2030, the average number of effective working hours lost in India could place 2.5% to 4.5% of GDP at risk annually.

Second, economic and financial systems have been designed and optimized for a certain level of risk. For example, many global supply chains and food-production systems prioritize efficiency over resilience, making them vulnerable to failure if intensifying climate hazards affect critical production hubs.

Furthermore, whereas property insurance is generally repriced annually, homeowners often have longer-term time horizons of 30 years or more on their real-estate investments. This mismatch exposes homeowners to the risk of higher costs, including rising premiums (reflecting higher risks) or reduced insurance coverage.

Third, financial markets could pull forward risks in affected regions, potentially triggering capital reallocation and asset repricing, as well as changes to the cost and availability of insurance. In Florida, for example, estimates based on past trends suggest that increased risk of tidal flooding alone could devalue exposed homes by between US$30 billion to US$80 billion, or 15% to 35%, by 2050, other things being equal.

Fourth, while the direct impact of climate change is local, it can have knock-on effects across regions and sectors as a result of interconnected socioeconomic and financial systems (as is also the case today with Covid-19). For example, we estimate that the direct damage to infrastructure assets from a 100-year flood in Ho Chi Minh City, Vietnam, could increase from about US$300 million today to as much as US$1 billion by 2050, while knock-on costs to the economy could rise from between US$100 million and US$400 million to between US$1.5 billion and US$8.5 billion.

Finally, climate change could affect the most vulnerable populations disproportionately, and could foster inequality by simultaneously benefiting some regions while harming others. (The pandemic is also exposing and increasing inequality in many countries.) In particular, climate events could double the likelihood of harvest failure in several agricultural breadbaskets by 2030 – meaning significantly lower-than-average yields in key production regions for rice, wheat, corn, and soy. This could lead to higher food prices, hitting the poorest communities – including the 750 million people living below the international poverty line – the hardest.

To mitigate the risk that ongoing climate change will jeopardize more communities and economies, businesses and governments must adapt now to the inevitable global warming that will occur over the next decade as a consequence of past emissions. And they must decarbonize to reduce longer-term risks.

The pace and scale of climate adaptation will likely need to increase significantly. Priorities should include protecting people and assets, strengthening resilience, reducing exposure to climate risks, and ensuring that appropriate financing and insurance are in place. Achieving these goals requires more intensive planning today, because implementing such measures could be difficult. The economics of adaptation could worsen over time in some regions, including those exposed to rising sea levels. In addition, adaptation may encounter technical limits or give rise to tough trade-offs, including who and what to protect or relocate.

There is a range of actions to consider. Businesses could weigh climate considerations in their capital allocation, product and service development, and supply-chain management. Cities could put climate risk at the centre of their urban-planning decisions, while financial institutions could do the same when managing their investment portfolios.

But although adaptation is now an urgent necessity, climate science has shown that the risks arising from further global warming can be stopped only by reducing net greenhouse-gas emissions to zero. Business and political leaders should therefore also consider potential decarbonization opportunities in parallel with adaptation investments.

The current pandemic has demonstrated how quickly global risks can multiply and spread, and why resilience and risk management are vital to protecting the world from other threats – and climate change in particular. As we have learned first-hand in recent months, the social and economic costs of failing to prepare for such risks are too high to ignore.

Hauke Engel is a partner at McKinsey & Company.

Mekala Krishnan is a senior fellow at the McKinsey Global Institute.

Copyright: Project Syndicate

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