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Speaking of the Economy
person researching climate change risks
Speaking of the Economy
July 20, 2022

Climate Change and Financial Markets

Audiences: Business Leaders, Economists, General Public, Policymakers

Toan Phan discusses the current state of research on climate economics and how the effects of climate change are reflected in financial markets. Phan is a senior economist at the Richmond Fed.



Tim Sablik: Hello, and welcome to Speaking of the Economy. I'm your host, Tim Sablik, an economics writer at the Richmond Fed. My guest today is Toan Phan. Toan is a senior economist in the Research Department at the Richmond Fed. His research focuses on the impact of climate change on the economy and financial markets. He was last on the show in November 2020 to talk about his work and the Fed's interest in climate change, and he joins me today to discuss some of his latest papers and work on this topic.

Toan, welcome back to the show.

Toan Phan: Thank you, Tim. It's good to be back.

Sablik: Most recently, you've been busy contributing to the Fifth National Climate Assessment. Can you tell us a bit about what that is and about your involvement in the project?

Phan: The National Climate Assessment is the major scientific report that synthesizes the state of the science on global climate change and its implications for the U.S. You can think of it as a place where policymakers, academics, businesses and citizens who would like a reliable source to understand and know what is the most up-to-date knowledge on this important topic and climate change and its impacts on the U.S. economy can go to.

It's a major scientific product of a federal research program called the US GCRP — the Global Change Research Program. It is overseen by 13 major government agencies, including NASA, the National Science Foundation, the Department of Defense, Department of Energy, and so on. The program was proposed by Reagan's final budget [in 1989], and then it was signed into law by George H.W. Bush in something called the Global Change Research Act of 1990. Its mandate is to develop and coordinate a comprehensive and integrated United States research program to assess, to predict, and to respond to human induced and the natural processes of global climate change.

I'm involved as an author in writing the first-time-ever economics chapter in the Fifth National Climate Assessment that is scheduled to come out next year.

Sablik: Great. As you mentioned, this is the first time that that report will include a chapter on environmental economics. How has that area of research evolved since you first started working in this space? Has environmental economics become more important to the policy decisions being made about climate change?

Phan: First of all, there's a big field of environmental economics. Now there is a related field, and I would call it climate economics and climate finance. It touches all sorts of disciplines within economics.

I started working on this topic about 10 years ago. Since then, I've seen a very rapid growth in terms of the papers that are being published in major journals, both economics and finance; in the number of working papers; in the number of economists who would be going into this topic from very different angles. I have colleagues who traditionally do macroeconomic or traditional econometrics, but now they are [applying] their existing knowledge in their respective fields to the questions that [are] very relevant for the topic of climate change.

On the policy relevance side, I think the literature is really trying to address some very important questions that all of us follow, including policymakers, citizens and business owners — people on the planet. The questions that we want to understand are things like how is climate change affecting economic growth? How is it affecting labor productivity, the patterns of migrations and patterns of immigration? How are climate risks affecting the financial market and our financial system, a topic that a lot of us are doing research on at the Fed and other places? The literature is also looking at the opportunities and the risks associated with the transition to a more sustainable economy. It's also talking about the costs and benefits of adapting to climate change.

Sablik: Yeah. I know you're probably limited in what you can say about the assessment itself, since it hasn't been released yet. But maybe you can talk a bit more about what you've personally learned from working on this project.

Phan: Part of me working for the National Climate Assessment is I have to read broadly about the recent literature on climate economics and climate finance. I've learned a lot. I think I can crystallize into three main takeaways what I personally have found to be quite interesting and surprising to me.

Sablik: Mm-hmm.

Phan: But before I begin, let me stress that these are my personal views and not the views of either the Fed or the views of the National Climate Assessment Team.

I think that there's evidence of climate adaptation in the U.S. However, surprisingly, the evidence is pretty mixed. On the one hand, there's evidence that we have adapted. In particular, there's a paper published a few years ago showing evidence that the adoption of air conditioning across the U.S. throughout the 20th century has substantially reduced the mortality effects of extreme heat in the country. I mean, this is intuitive. It's evidence, yes, society, we have adapted, reducing the negative damage from [the] rising incidence of extreme heat.

On the other hand, there's also a lot of evidence of limits of adaptation around the world, but in particular the U.S. There's another paper by some colleagues of ours in the University of California system. They documented that between 20 years from 1980 to 2000, adaptation has mitigated between zero to less than a half of the negative impacts of extreme heat on crop yields, using data from agricultural yields across the U.S. So that's, you know, the best adaptation can do, to some extent. Somehow, farmers are somehow reluctant to [deal with] this changing incidence of heat.

I think there is an even more striking finding that's been found in several different papers. They found that the U.S. is particularly exposed to cyclone or hurricane damage. Just to get a big picture, in the U.S. we account for roughly 60 percent of global cyclone damage, as measured in dollars in property damage. But we are struck by only about 4 percent of cyclones around the world. The U.S. exhibits rates of property damage and mortality much higher than those of other exposed wealthy countries like Japan or Australia. Our rate of damage is somewhat similar to those observed in places like China or India.

Sablik: Mm-hmm.

Phan: I don't think there's consensus as to why the U.S. may be an outlier when it comes to the rate of damage from the wind speed of a cyclone. It might be the cost of adaptations such as building infrastructure, houses and roads that are more resilient to hurricanes and cyclones is more expensive in the U.S. compared to Japan. Or, maybe there is weaker incentive to adapt.

So the first thing I took away was that, yes, there's some evidence of adaptation, but let's be careful. So far, the evidence of whether, even a developed country as the U.S., whether we have adapted. In looking at historical data, the evidence is mixed.

Number two is something that's getting more attention — climate-related migration, things like climate refugees or environmental migrants. There is a body of work in the climate economics literature that has documented and predicted that sea level rise and the increase in climate-related disaster risk can reshape the population landscape in the U.S. It can also change the pattern of immigration to the U.S.

I'll give you a concrete example — a well-known paper published in the Proceedings of the National Academy of Sciences in 2010. Using historical data, they documented that reduction in crop yields in Mexico due to adverse changes to temperature and rainfall there was associated with an increase in rates of immigration from Mexico to the U.S. Using these estimates, they predict that by 2080, at these current rates, climate change is estimated to induce something between 1.4 to 6.7 million adult Mexicans to immigrate to the U.S. The potential economic [and] political implication of such large migrations or such large flows of climate refugees and environmental migrants remains an open research question. That's something we started to pay attention to, but a lot more work has to be done.

Sablik: Mm-hmm.

Phan: The third takeaway point is that the market responses — including the kind of responses that we see in the financial market by borrowers, by lenders [and] by insurers — could complicate the direct damages of climate change in nontrivial ways.

Sablik: I really appreciate you sharing those insights that you gained from this work.

I want to pick up on that last point about the market responses and how those might complicate or amplify climate costs. That sort of pertains to another topic, which I know you talked about the last time you were on the show, but it's a question that comes up pretty often so it's worth revisiting.

Some have argued that climate change sits outside of the Fed's mandated focus on price stability and full employment. On the other hand, a number of Fed officials have responded that it's important for the Fed to understand the potential risks and costs that climate change could impose on the economy and the financial system. You have a pair of recent Economic Briefs that explore this issue specifically, and we will put a link up to those in the show notes. I'm wondering if you can tell us what you found in those papers since it seems especially relevant to the Fed's interest in climate change.

Phan: Sure thing. There are useful lessons from the Great Recession, and one of them is that the financial market and its reactions could amplify what seemed to be initially some small shock.

Back in the days [before the Great Recession], there was a small shock [and] some initial losses in the subprime mortgage market. Then the reaction in the financial market amplified those initial small damages, and that caused the Great Recession and eventually the global financial crisis. Seems to me, some of those kind of amplifications may be playing again here when it comes to how financial markets may potentially amplify the direct climate damage.

There is some recent work that document empirical evidence that a large hurricane — for example, Hurricane Sandy that struck New York and New Jersey — not only caused direct damages to New Jersey and New York coastal properties, but they also cause a relative decline in the values of at-risk properties elsewhere. Hurricane Sandy actually caused a decline in the relative value of coastal real estate value growth in Boston, despite the fact that Boston was not at all hit. The direct damage of the hurricane was amplifying the loss in the values of properties elsewhere.

Sablik: Mm-hmm.

Phan: This is likely because of homebuyers or investors updating their belief and attention to climate change after seeing such large climate-related shocks. So, a lesson for me is the impact of climate-related disasters is not only the direct damage on its path but also in the information and content, the news that people can perceive from it. If I'm an investor, I see this climate-related shock. If it makes me more attentive or update my belief on climate change, that might make me change the way I buy and sell investments. This has an effect on coastal real estate values, right?

Sablik: Sure.

Phan: In some recent work I've been working on with my co-authors, we found out that the reaction in the financial markets could shift and concentrate climate risks in nontrivial ways.

In a working paper I have with Russell Wong, a colleague at the Richmond Fed, and Laura Bakkensen at the University of Arizona, we find evidence — pretty robust evidence — that some homebuyers, those in particular who are more concerned about future climate change, are strategically shifting the increased flood risk due to sea level rise to lenders via checking out debt in the mortgage market to finance the purchases of coastal properties that are exposed to future sea level rise risk. Our work and also some recent work in the literature have documented that banks, in turn, could shift such climate-related risks to the government-sponsored enterprises — also known as the GSEs Fannie and Freddie Mac — via the process of securitization.

This pattern of climate [risk] reshifting is similar to the kind of financial risk shifting that we saw in the build up to the Great Recession, where some homebuyers [made] leveraged bets by buying houses with debt, shifting the some of the risks to the lenders. The lenders — the banks, in this case — [were] transferring some of these risks by securitizing these mortgage contracts and selling these securities to the government-sponsored enterprises, therefore effectively transferring this default risk. Once the shock hit, the subprime market collapsed and the government-sponsored enterprises faced huge financial stress and eventually had to be bailed out by the government.

To be clear, how big and important climate risks [are] to the financial system at large is still an unanswered question. It's actively being investigated by the literature. For example, there is a lot of work about stress testing the banks and insurers to [address] changes in the pattern of climate-related disasters, or other kinds of scenarios. A lot of our colleagues in the Federal Reserve System and elsewhere in academia are doing that.

Sablik: That raises a good point. This is still, obviously, ongoing investigation, ongoing research.

It connects to another criticism of the Fed's climate change research. Some people have expressed concerns that monetary policymakers may be focusing too much on climate financial-related risk at the expense of other financial risks. I'm curious how you would respond to those criticisms and how you see your research in the context of the overall research agenda at the Fed, whether you personally have any sort of sense of how climate-related financial risks compared to other risks that could be facing the financial system, such as things that we've seen in recent years like war, pandemics, or other crises.

Phan: Let me try to tackle the question you raise: How do the climate related risks compare and relate to other sorts of risks like wars, epidemics, and other kinds of financial crisis?

Climate change, as we all know, is a new kind of source of risks to the global economy. It's been there for a long time but now becoming more salient to policymakers to academics, researchers, to average households. While we have had centuries of data to help us understand the economic and financial implications of other disasters such as wars, we researchers are only beginning to scratch the surface of the economic and financial effects of climate change and the effects of the way in which firms, banks households, institutions react and adapt to climate change. Like I mentioned to you, the research is still very young. And the way that the market reactions to climate change affect the economy, we are only starting to scratch the surface.

Back to this comparison to other kinds of risks. Climate risks interact with other kinds of risks. For example, my co-authors in the National Climate Assessment economics chapter have written papers documenting evidence that climate change increases the risk of wars, especially in less developed countries with weaker institutions, right? There is a possibility also currently being studied in the climate science literature that climate change and the destruction of the natural environment might be contributing to the increase the risk of epidemics.

In a sense, climate change could amplify, could increase the risk of other disasters. So, I think it's important to study them in conjunction.

Sablik: Mm-hmm.

Phan: We shouldn't be studying them in silos. In fact, there's several works published in top economic journals even 10 years ago arguing that when we have such large disaster risks, we shouldn't think of them separately. We should think of them in comparison because the different sorts of risks might interact.

Finally, much of my thinking about climate economics has been influenced by the research and the writings of the late Martin Weitzman, a famous economist at Harvard who passed away recently. In his book, Climate Shock — which I highly recommend for anyone who wants a general audience book about climate economics — he argued that climate risk has a small but nontrivial chance to cause very serious economic and political damage to the global economy, and even to the greater human civilization. So, for institutions, for people [and] for researchers who are concerned about systemic risk and about potential stress to our [financial system and] trade system, I think it would be wise first to understand, to pay some attention to what some potential implications that climate change may have, even if they have this "fat tail" characteristic.

Sablik: Right. You mentioned this is still a young field and there's a lot of more research to be done. Maybe you can give us a sense of what you're working on now or looking to work on next.

Phan: We have several projects in the pipeline. For example, we are trying to understand how banks adapt to climate change in their lending activities. There's a lot of work in the climate economics literature about how the economy is adopting better crop varieties in agriculture, may be taking on insurance, may be raising a house on stilts, or migrating away from areas exposed to sea level rise and coastal areas with recent flooding. Much less is being done about how financial markets adapt to climate change. The previous work I mentioned with Russell Wong and Laura Bakkensen is one of our first approaches to understanding [what] adaption looks like. In some ongoing work right now, we try to consider how banks are doing that. We're using banks' data [and] regulatory data to see how their behaviors might change in response to climate-related news [and] shocks.

We also have a different project trying to understand where the scientific uncertainty about the degrees of damage of sea level rise affect housing market prices, in other words how uncertainty is being priced or not in the market. The housing market is very interesting because housing, as you know, is a durable asset. It's not movable, or it's very hard to move. [Laughs] So it's a very good place for us to understand whether the buyers, the investors, the markets think about future risks, how we think of the uncertainty that's underlying these kind of risks.

I also have other works with co-authors trying to understand the unequal exposure to flood risks across different socioeconomic groups. We are combining exposure-to-flood-risk maps with historical redlining maps and we'll see if there's a relationship here.

I think the community of researchers in climate economics and finance is pretty friendly. From my experience [co-organizing] with my colleagues in San Francisco and elsewhere the San Francisco Fed's Virtual Seminar on Climate Change for more than two years now, it's a nice group of people. And it's growing very, very rapidly.

Sablik: Great. That's, as always, a good opportunity for me to remind listeners who enjoy today's conversation on this topic to check out our website at, where they can get in touch with you and also keep up with the latest work that you and our other economists are doing.

That's going do it for our conversation today. Toan, thanks very much for joining me to talk about your research. Hope to have you back on again soon.

Phan: Thank you so much, Tim.

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