The fallout from glo-bal warming is a very real threat to all businesses, and the financial services industry is sure to be impacted by the market storms that will erupt as industries around the world take varying levels of interest in dealing with the change.

The latest report by the United Nations Intergovernmental Panel on Climate Change, released in early February, says global warming is an “unequivocal” reality. It says climate change is evident in observations of rising air and ocean temperatures, widespread melting of snow and ice, and rising sea levels.

One of the chief implications of global warming is not only higher median temperatures but a variety of spinoff effects, such as more extreme weather. The effects in the years ahead appear monumental. The panel predicts continued warming will bring more droughts in tropical and subtropical areas, more heat waves, more frequent storms, more intense tropical cyclones, typhoons and hurricanes, and a continuing rise in sea levels.

The net effect is expected to echo throughout the global economy, a case that was made last year in a report for the British government written by Nicholas Stern, former World Bank chief economist. Without immediate action to mitigate climate change, that report said, global gross domestic product could take a 20% hit.

It’s easy to see the impact on the financial services industry, given its position at the heart of the global economy. Any damage to the overall economy would be felt in financial markets. Commodity prices, and the fortunes of the energy sector and other heavy polluters, such as manufacturers, could be significantly affected by policy decisions to restrict greenhouse gas emissions.

The latest version of the annual risk outlook report published by Britain’s financial industry regulator, the Financial Services Authority, singles out climate change as a real risk for the financial services sector. The FSA report states: “The impact of climate change on global GDP, through increasing damage to infrastructure and loss of life, is likely to be considerable.”

The FSA points out that extreme weather could disrupt business and imperil companies’ physical assets. It predicts this will generate equity market volatility, and more volatile investment returns for wholesale and retail investors.

Some financial services firms are beginning to recognize the significance of the risk. In a report published at the end of January, UBS Wealth Management Research assessed the investment risks and opportunities of climate change. If action isn’t taken to reduce emissions meaningfully, it says, “Investors would be best served by reducing the direct physical risk climate change could have on their portfolios.”

UBS also points out the investment opportunities related to mitigating climate change — namely, investing in energy-efficient products and the development of renewable/low-carbon energy sources.

“The more incentives that emerge to encourage people to limit greenhouse gas emissions, the greater the outlook for investment opportunities related to climate change mitigation,” the UBS report counsels. “In our view, it is the prospect of individual behaviour proliferating on a large scale, combined with more stringent regulation of greenhouse gas emissions, that makes the opportunities related to climate change mitigation a compelling investment case.”

Without social change and political action to limit climate change, the industry and equity markets will have plenty of environmental risk to face — beyond the threat posed to global GDP.

The FSA argues the threat is much more tangible, as the physi-cal effects of a dramatically different climate could undermine key elements of the financial services industry: “The financial centres of London, New York, Tokyo and Hong Kong are all located in coastal areas, and are likely to be particularly affected as flooding increases and changes in soil composition weaken buildings’ foundations.”

And the increasingly global nature of the financial system could also make it vulnerable, the FSA report adds: “Increasing use of offshore centres for outsourced financial services exposes the global financial system to climate change, as extreme weather and a rise in sea levels destroy infrastructure around the world.”

Infrastructure damage, in turn, would degrade the value of the collateral held in the banking system, generating more insurance claims.

The insurance industry would feel the impact of the changes almost immediately. Not only would valuable commercial real estate be at risk, but, the FSA says, insurers could also face rising personal and commercial claims resulting from intense weather. It warns that the correlation of seemingly unrelated events will probably also increase, putting pressure on insurers.

@page_break@“Climate change is likely to increase the cost of capital markedly, as investors demand a higher premium for putting capital at risk,” the FSA predicts. “This would result in uncertainty in capital markets across different asset classes.”

The risks aren’t just speculative. A report commissioned by Boston-based Ceres Inc. , a coalition of investors, environmental groups and other public-interest concerns, says top U.S. financial services firms have already suffered substantial, although not always material losses associated with severe hurricanes. Yet, despite the risk climate change holds for the financial services sector, the Ceres survey ranked the sector last among companies in the S&P 500 composite index, in terms of the level of disclosure firms provide.

Nevertheless, a recent briefing on adapting to climate change by the Conference Board of Canada suggests the financial services sector may find itself at the centre of the effort to mitigate global warming and deal with its effects.

The briefing calls on corporate risk managers to bring the issue to the attention of senior management, and adds that financial markets may perform the function: “If the financial community begins to include a company’s climate-change strategy in its investment criteria, it may adjust credit ratings or insurance rates. This, in turn, will affect the company’s ability to attract capital. It can also decrease opportunities and rate of return — factors that affect profit and costs.”

If the financial services sector starts to pay attention to the issues, the Conference Board says, it can push the rest of corporate Canada to take notice: “Incorporating adaptation into a company’s risk assessment will drive change in one organization, but incorporating adaptation in the financial services sector will drive change throughout all organizations in all sectors.”

Public opinion may also prompt firms to pay more heed to their environmental impact. “Firms not seen to be acting in either the best interest of consumers as the external environment changes or minimizing their impact on the climate could face severe reputational risk,” the FSA warns, leading to potential loss of clients or litigation.

Risk premiums could be affected in other ways. The FSA notes the effects of climate change, and the resulting losses, will probably be distributed unevenly around the world, leading to “considerable population migration and regional conflict.” It says emerging-markets spreads could widen as a result.

The financial services industry has been ingenious at crafting products that allow companies and investors to hedge risk, and the increasing importance of environmental risk is expected to drive future innovation. But, the FSA warns, this could bring a whole new set of risks to the industry.

Development of new markets is inherently uncertain. A example of the difficulty is the European carbon-trading markets that were launched to enable firms to reduce their emissions efficiently. Governments issued too many permits, which kept the price of carbon low and didn’t do enough to reduce pollution.

With experience, markets become more effective and efficient, but their efforts remain at risk until their players gain experience. After all, even well-developed, intensely studied and highly efficient markets, such as the U.S. stock market, confound even the smartest and most experienced players. And, as any farmer can tell you, venturing into markets dependent on something as unpredictable as the weather is rife with uncertainty.

The FSA notes that weather-linked financial instruments are highly sensitive to the accuracy of their underlying models and the data used to build the models. Yet, it adds, “A key feature of weather and climate change is that it is highly unpredictable. This means any increase in global mean temperature could alter the accuracy of models as traditional feedback loops that have kept the global ecosystem balanced could reverse, stop working or accelerate.”

While the effects of global warming on companies and economies are unpredictable, given its scale, scope and mystery, financial services firms are sure to be at the eye of the storm. IE