The Globalization of Climate Change

Climate economic models have “a long history of being unrealistically optimistic” in part due to a consistent failure to account for cross-border economic and trade interconnections. This paper from the European Central Bank (ECB) addresses this limitation, introducing a methodology to assess how global supply chains amplify climate-related physical risks.

The results reveal that traditional GDP loss estimates may capture as little as 3.3% of the true GDP-at-risk in the euro area once trade interconnections are taken into account.

The authors, Stephen Fahr, Richard Senner and Andrea Vismara, “illustrate the simple yet underdeveloped finding that physical risk can only be grasped after taking supply-chains into account”.

By largely excluding these dynamics, the authors say that the ECB’s stress tests likely represent a substantial underestimation of climate risk, hindering the political will necessary for appropriately ambitious action. For instance, the ECB’s climate stress test in 2022 estimated that physical risks would result in losses of less than 1.5% for physical assets by 2050 in an adverse scenario.

“It is not surprising that these kinds of scenarios have not scared policy makers or chief risk officers of financial institutions who have experienced larger shocks in 2008 or who must shock their systems with more adverse scenarios in regular stress testing exercises,” the report says.

This study employs a novel approach, integrating country-level GDP losses from climate-related physical risks with a global input-output (IO) model. This methodology allows for observations on how initial GDP shocks propagate through global supply chains.

The methodology involves a bottom-up approach using the Organisation for Economic Co-operation and Development’s inter-country IO tables and S&P Global’s GDP-at-risk data. The IO model simulates supply and demand shocks, incorporating the possibility for country-sectors to reallocate input sourcing, which can mitigate losses.

The results show that including such effects can potentially see losses amplified by up to 30 times higher than direct impacts alone. Under the representative concentration pathway (RCP) 8.5 scenario in 2050, the euro area could face aggregate GDP losses exceeding 10%, significantly higher than direct climate shocks would suggest.

Countries with high exposure to climate change, like those in the Mediterranean, and those with extensive trade connections, such as Germany and Luxembourg, are particularly vulnerable.

“Flows of commodities and goods, as well as people, finance, and innovation, can be driven or disrupted by distant climate change impacts on rural populations, transport networks and commodity speculation,” state the authors.

Key sectors such as wholesale and retail, real estate, and construction are expected to incur the most substantial losses, with spillovers into finance and insurance.

The authors recognise a significant limitation of the model is that it does not account for macroeconomic variables like prices and employment, which could be included in future research.

The paper calls for more granular, forward-looking global physical risk data, considering factors like biodiversity loss and tipping points. It emphasises the need for a holistic approach, incorporating factors such as  disease, migration, political instability, and the substitutability of critical outputs, particularly in food and technology sectors.