The dance of the climate crisis

You may have already noticed that we are in a climate crisis. But have you ever considered how strange the choreography of those two words is? We know about climate. We experience it every day, and it tends to be pretty stable. We also know about crises. In the last hundred years or so we have seen wars, economic and financial crashes, and pandemics.

So, if we put the words together – ‘climate crisis’ – what can we learn today? More importantly, has the investment industry learned enough from past experience to make sense of it and its unfolding?

As in any crisis, spotting early warning signals is key. In this piece, I will attempt to point out where the industry can look, by outlining the steps and rhythm of a generic crisis and applying them to the current climate one. The high-level view is that, in systems, outputs are determined by the combination of inputs and processes. A crisis, or bad output, is caused either by extreme inputs (shocks) or by a non-linear process (a small change in input is transformed into a bigger-than-expected output).

The first steps: a shock hits

In the current climate crisis, the Earth’s environment has been stressed by a big rise in emissions due to human activities. In just the past 200 years, the concentration of carbon in the atmosphere has risen more than 40%, much of this since the 1970s. This “recent increase is unprecedented in the past 800,000 years”[1].

While it is helpful to identify the source of the shock, there is a bigger problem in that humans seem to perceive environmental changes as occurring more slowly than they actually are. To put this into perspective: “[the] speed of warming is more than ten times that at the end of an ice age, the fastest known natural sustained change on a global scale”[2]. It’s incredible how far from our perception this finding is.

So, there is no doubt we have spotted the shock. What now?

When a shock hits a system, different parts of the system tend to move together either as a direct consequence of the shock or because the shock introduces uncertainty. In financial jargon, this is expressed as “correlations going to one” (different prices dance in lockstep). In addition to becoming synchronised, the movements tend to get bigger (variance increases).

The next movement: high sync, growing uncertainty

A while ago we entered a phase where human and natural systems became, and continue to become, more correlated – they influence each other more.

Some parts of the planet may be experiencing climate change more acutely than others, but weather patterns are becoming more synchronised and more volatile.

The economy is also trying to cope, adapt and react, each sector using its own tools and rules. The investment industry, for example, is responding by looking to ESG criteria and for more sustainable investment opportunities. The growing interconnection between investment and the natural world is also seen in the recent rise of impact investing, and concepts like double materiality.

Essentially, the two systems are more in sync than ever before.

As for increased variance, we can already see this at the climate level, but arguably not yet at the economic and financial level.

One reason why financial markets have not yet registered a rise in volatility is that climate risk may not be fully reflected in asset prices. As a result, the sudden price adjustments have not yet been experienced[3]. Given the dynamics described above, a large price adjustment seems more and more likely now. So, we have not yet fully completed the first steps of this dance…

Divergent duet: lower sync, higher variance

It is very important to understand where this dance (the system) might be heading – either (a) towards the bottom of the crisis and subsequent recovery (the dancers return to a familiar pattern) or (b) towards tipping points with no chance of recovery (the dance becomes wild).

Path (a) is essentially a climate-induced financial crisis. The recovery phase implies disciplined decarbonisation and a successful limiting of temperature rise.

With path (b) the processes that turn inputs into outputs would now be different – when the stress becomes too strong and the system tips, behaviours change. New behaviours cause new correlations to emerge. But in the discovery phase – what are these behaviours? and what correlations should we expect? – variance will be high.

For example, as climate conditions worsen, humans may heavily prioritise adaptation against mitigation measures. They do less to curb climate change; they do more to protect against it. Negative social tipping points will be part of this new setup of increased variance.

The uncertain finale: can we say anything about the ‘other side of the crisis’?

The second path is problematic because there is no clear way to tell when we are on it. It is therefore advisable to look for early warnings of climate-related risks building up in markets displaying decreasing correlations and increasing variance. What follows is a speculative list of some potential events:

  • Breakdown of historically stable relationships between asset classes
  • Sharply diverging stock price performance between sectors previously viewed as correlated
  • Severe losses and insolvencies triggered by climate events
  • Spike in idiosyncratic stock return volatility as climate impacts become highly firm-specific
  • Drop in prices for climate-vulnerable assets as physical risks are suddenly recognised
  • Wider credit spreads for high-carbon issuers independent of broader market moves (analogous to stranded carbon assets)

I aimed to provide a systems-friendly glimpse into the potential unfolding of the climate crisis. I considered correlations and variance as system features that can say something meaningful about what to expect. We are still very early in this climate-crisis dance and we are only at the beginning of an intricate interplay between the climate and human/financial systems.

We have fewer predictive tools to navigate the climate crisis of tomorrow, but we do have narratives as cognitive building blocks to make sense of the unfolding reality.


[1] Climate is always changing. Why is climate change of concern now? The Royal Society

[2] Ibid

[3] Asleep at the Wheel? The Risk of Sudden Price Adjustments for Climate Risk, Riccardo Rebonato. https://climateimpact.edhec.edu/publications/asleep-wheel-risk-sudden-price-adjustments