Key facts
- The increasing frequency and severity of extreme weather events are making it difficult for insurers to price risk, leading to a widening 'protection gap'.
- Difficulties in pricing climate risk are expected to have broader knock-on effects across the financial system, impacting bankability and investability.
- Global adverse weather events, such as heatwaves in West Africa, are contributing to UK inflation, particularly in food prices.
- Raising interest rates to counter climate-driven inflation could increase the cost of essential investments in net-zero transitions and climate adaptation.
- Monetary policy is considered a blunt instrument for addressing relative price shocks stemming from climate change and energy markets.
The UK economy is facing significant repercussions from the climate crisis, extending beyond immediate weather impacts to broader financial and inflationary pressures. A report by The CityUK, in collaboration with insurer Marsh, highlights the growing challenge of insuring against increasingly frequent and severe extreme weather events. Traditional actuarial methods are becoming unreliable as climate hazards intensify, leading to a widening 'protection gap' where homes and businesses are left uninsured.
This difficulty in pricing climate risk is not confined to the insurance sector but is expected to have knock-on effects across the financial system, impacting bankability and investability. The report warns of a potential vicious cycle where insufficient spending on climate adaptation increases damage costs, which in turn raises investment costs as insurers and lenders seek to recoup losses.
Economist Swati Dhingra, a member of the Bank of England's Monetary Policy Committee, has also pointed to related issues, specifically the impact of adverse weather events worldwide on UK inflation. She cited chocolate prices as an example, contributing significantly to UK food inflation due to extreme heat in West Africa affecting cocoa production. Analysis from the Energy and Climate Intelligence Unit (ECIU) further supports this, showing a substantial portion of UK food imports come from climate-vulnerable countries.
Dhingra argues that using interest rates to combat climate-driven inflation can paradoxically increase the cost of crucial investments in the net-zero transition and climate adaptation. She suggests that monetary policy is a blunt tool for such relative price shocks and that governments may need to implement targeted support measures for consumers, allowing central banks to focus on broader inflation expectations and stability. This approach could involve subsidies, price controls, or temporary tax measures, especially as policymakers become more accustomed to market interventions following recent global shocks.