Top 5 ways climate change could impact economic activity in the coming decades

Extreme weather events such as droughts, floods, heatwaves, cold snaps, storms and wildfires are likely to become increasingly common over the next few years due to climate change, potentially causing significant human casualties and economic damage in the process. Here are the five major likely economic impacts of an increasingly volatile climate:

1. Direct economic damage

Extreme weather events can directly harm individuals, damage buildings and undermine infrastructure. The wreckage that such disasters leave behind requires significant repairing and rebuilding in order for communities, and indeed economies, to return to functioning. In the Philippines for instance, the recent Typhoon Rai, which destroyed homes, ruined crops, inundated villages and uprooted power and communications infrastructure, was the latest in a series of typhoons which have cost the country USD 1.2 billion per year on average between 2000 and 2016, according to one estimate from the Asian Development Bank.

In wealthy countries, human casualties from natural disasters tend to be fewer than in developing countries, due to better early warning systems and a greater response capacity. However, even in these contexts, the cost of extreme weather can be stark in economic terms. The National Oceanic and Atmospheric Administration put the total cost of extreme weather events in 2021 in the U.S. at USD 145 billion, with notable events including Hurricane Ida, wildfires, and a deadly heatwave in the West.

On a global scale, one study puts the cost of extreme weather events at USD 3.6 trillion over the last five decades. Three of the 10 costliest hurricanes in U.S. history occurred in 2017: hurricanes Harvey, Maria and Irma.


2. Reduced productivity

Secondly, a higher frequency of extreme weather events threatens increased negative shocks to productivity. To begin with, extreme heat and cold can make it impossible to work. Extreme weather can also hamper productivity by damaging infrastructure and contributing to power shortages. Furthermore, extreme weather events may harm workers’ health. Floods, for example, may increase an individual’s risk of developing gastrointestinal illness, while drought may cause malnutrition and contribute to the spread of waterborne diseases as a result of more limited access to clean drinking water. Natural disasters also pose a risk to mental health, particularly if they result in a large disruption to an individual’s regular living arrangements, bereavement or forced displacement. This could, in turn, result in reduced productivity.

Let’s look more closely at heat as an example. Take Iraq: Last summer the country suffered significant economic disruption from power cuts amid soaring temperatures. As the country’s summers have become longer and drier, electricity demand increases as air conditioners are switched on. Simultaneously, electricity supply is stymied as hot weather causes electricity generators to run less efficiently. A repeat of such electricity shortages poses a significant threat to Iraq’s economic prospects ahead. The picture is similar in wealthier nations. In Europe, a recent study in the journal Nature put the economic burden of heatwaves at 0.3–0.5% of GDP in the years that they occurred. In the case of the U.S., a report by the Atlantic Council estimated that by 2050, productivity-related losses due to extreme heat could amount to half a trillion dollars annually.

3. Inflationary spikes

Extreme weather events also pose risks to price pressures. On the upside, events such as droughts or floods could lead to a reduction in food supply and damage infrastructure, hindering the transport of goods. In the Philippines for instance, Typhoon Rai threatens to cause inflation to spike early this year amid significant damage to agricultural land. Likewise, in Haiti, an earthquake and subsequent tropical storm Grace caused significant damage to agricultural land and critical infrastructure last year, contributing to the recent spiral in inflation—which hit 24.6% in November 2021.

However, downside risks are also present. Natural disasters can dampen economic activity and consumer spending, for instance, leading firms to lower their prices in response. Furthermore, rebuilding efforts in the aftermath of a natural disaster could boost supply and push down price pressures in the medium term.

The overall impact of natural disasters on inflation is thus ambiguous, depending crucially on the type of disaster, its intensity and duration, and the country affected. In general, developed countries are less likely to see strong price swings than developing countries.

4. Financial market risk

The fourth impact of higher-frequency extreme weather events is a potential increase in financial market risk. Although in the past the impact through this channel has been more muted compared to those aforementioned—with 2005’s Hurricane Katrina causing the New York Stock Exchange to move less than one percentage point despite causing USD 150 billion in direct damages—as extreme weather events increase in severity and frequency, the financial market impact is likely to be exacerbated.

For instance, financial institutions with assets in sectors likely to be especially hard hit by extreme weather events—such as agriculture or tourism—could see their balance sheets hit significantly. Losses incurred by insurers are also likely to rise sharply, while potential large-scale conflict or mass migrations as a result of climate change could heavily affect firms’ profitability and financial market activity more broadly. Plus, if natural disasters lead to a sudden shift in government policy—such as a snap decision to ban polluting activities—this would weigh heavily on asset prices in the fossil fuel sector. This could in turn cause problems for banks and other corporates with investments in the fossil fuel space, potentially leading to a wider market sell-off.

In recent years, monetary authorities have begun to take more notice of the financial risks of climate change. Former Bank of England Governor Mark Carney highlighted these risks as early as 2015, while central banks such as the European Central Bank have begun to undertake climate change risk stress tests on financial market institutions.

5. Increasing inequality between- and within-country 

Finally, increased extreme weather events threaten to widen between- and within-country inequality. In developing nations, large fractions of the population directly depend on sectors, such as agriculture, which are likely to be hardest hit by extreme weather events. In contrast, developed nations rely more on higher value-added services which are more immune to climate change. Developing nations also tend to be in parts of the world with more extreme climates, compared to the temperate conditions prevalent in much of the developed world. As such, the gap between rich and poor economies could widen in the absence of comprehensive climate change mitigation strategies.

Meanwhile, within countries, lower-income households are likely to suffer especially significant economic losses from extreme weather events, as they are less likely to be able to afford insurance which protects against climate risks. Moreover, they more commonly work in agriculture and live in homes which are less fortified against the elements.

The upshot

While extreme weather events are virtually certain to become more common over the next few decades due to climate change, whether the economic cost of these events rises in tandem depends crucially on the extent of adaptation and mitigation efforts. In order to be successful, these efforts would likely require substantial financial support from developed to developing nations in order to help the latter adapt to a changing climate, alongside a two-way flow of strategy and best-practice sharing to ensure disaster readiness for all. Of course, a far more optimal solution to minimize climate-related economic damage would be to rapidly accelerate the green energy transition—but this currently appears a fairly distant possibility.

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinion of FocusEconomics S.L.U. Views, forecasts or estimates are as of the date of the publication and are subject to change without notice. This report may provide addresses of, or contain hyperlinks to, other internet websites. FocusEconomics S.L.U. takes no responsibility for the contents of third party internet websites.

Author: Matthew Cunningham, Associate Economist

Date: February 15, 2022

Twitter @FocusEconomics

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