Are financial services underestimating tomorrow’s risks?
The escalating impacts of the climate crisis have prompted experts to critically evaluate the current state of climate-scenario modelling within the financial sector. The key issue isn't whether we acknowledge climate change risks but how significantly we might be underestimating them.
The existing disconnect
There's mounting unease about the pronounced disparities among climate scientists, economists, and those who utilise models in financial services. Nassim Nicholas Taleb poignantly captures this sentiment, stating: “A model might show you some risks, but not the risks of using it. Moreover, models are built on a finite set of parameters, while reality affords us infinite sources of risks.”
“Climate change is complex, nuanced, and characterised by deep uncertainty.”
The dominant climate models in finance might set us up for a sudden and wealth-destroying correction, a “Minsk Moment.” Recent findings are startling. Many pension funds use models suggesting minimal portfolio impact from global warming of 2 to 4.3°C. They base this on economic models that see continued growth even with 5 to 7°C global warming. (source)
In contrast, other sources predict a GDP loss of up to 65% if climate change is not mitigated. These might even be conservative estimates. (source)
Essentially, there's a massive gap between what scientists expect from global warming and what pensioners/investors/financial systems are prepared for.
The roots of the problem
Recent studies reveal concerning patterns:
The disconnect between economists and climate scientists
There's a stark disconnect between the realm of climate science and the underpinning economic models in financial services. Important aspects such as tipping points, sea-level rises, and mass migration often get overshadowed.
“The climate is a complex system, and complex systems resist change up to a point. When that point is exceeded, they can move with alarming speed.”
The DICE model's limitation
The DICE model, introduced by William Nordhaus, has become the cornerstone of economic climate change predictions. Yet its simplicity may be its undoing. As Steve Keen emphasises, this model makes vast generalisations, indicating that a 6°C temperature rise would still leave 87% of GDP untouched. This perspective starkly contrasts with observations from other experts in the field.
“The current state of climate change modelling is a bit like trying to predict a ball’s trajectory without taking gravity into account.”
Data limitations
Many models predict future damages based on historical data, presupposing that future damages will mirror past ones. But given the nonlinear trajectory of climate impacts, this approach is flawed. The NOAA's database, which records climate events resulting in damages exceeding US$ 1 billion from 1980 onwards can be used as a more accurate source. These events and their rate of acceleration provide a much clearer picture of the potential damage caused by climate change.
Malachi Brooks on Unsplash
Our carbon budget
Another cornerstone of climate-related financial modelling, may be shrinking faster than we realise. Earth-system models indicate a faster-warming planet, translating to more acute physical risks and a higher probability of hitting climate tipping points.
“There are a large number of uncertainties that impact upon estimates of the remaining carbon budget. … There is a possibility that the remaining carbon budget for limiting warming to 1.5°C is already zero.”
The perils of groupthink
Regulators, in an attempt to establish consistency, might inadvertently be encouraging groupthink. This runs the risk of outcomes being interpreted too literally, leading to a false sense of security in financial stability.
So, what does this all mean?
For professionals in finance, it's evident: models need revising.
Current models, though endorsed by regulators and visionaries, have shortcomings. The importance of understanding the assumptions and limits of models cannot be overstated. Silos between climate scientists, model builders, and decision-makers in financial services need to be broken down to make scenario modelling more reflective of climate science realities.
It's time for a fresh approach.
We must consider both qualitative and quantitative measures. Using tools like visualisations, such as flood maps comparing different temperature scenarios, can provide an illustrative look into potential future risks. Furthermore, a 'reverse stress test' approach, common in financial services risk management, could help provide more realistic outcomes. (source)
How Might We Move Forward?
To truly understand and prepare for the financial implications of climate change, we need to address some key questions:
How might we integrate real-world climate data, in all its complexity, into our financial models?
How can we foster a deeper understanding between climate scientists and financial decision-makers?
What proactive steps can be taken to ensure our models are resilient, adaptive, and constantly updated to reflect the dynamic nature of climate science?
How can qualitative scenarios complement our existing models, offering a more comprehensive view of potential risks and outcomes?
The financial world stands at a crossroads. While climate change poses undeniable risks, there's also an opportunity – for preparedness, adaptability, and resilience. By asking the right questions and constantly reassessing our models, organisations and individuals can better equip themselves against the impending impacts of the climate crisis.
While I may not be a climate scientist or an expert in risk modelling, I excel at bringing together a diverse group of specialists. My strength lies in facilitating workshops that align teams, foster collaboration and bring a systemic perspective.
Whenever you are ready to bridge the gap between diverse expertise and craft a resilient strategy, let’s talk.
