Thierry Philipponnat, Chief Economist at Finance Watch, warns that economic modelling must evolve to prompt policymakers to take action on climate.
Almost seven years since the Paris Agreement was signed at COP21, any number of initiatives have been launched with the aim of reducing greenhouse gas (GHG) emissions and limiting global warming to 1.5°C. But a severe disconnect between climate science and the modelling shaping economic and financial policy remains, feeding climate inaction.
“I hate to say it, but global warming has surpassed 1.5°C,” Thierry Philipponnat, Chief Economist at Finance Watch, tells ESG Investor, citing a report by the World Meteorological Organization (WMO), which noted a 66% chance that the annual average near-surface global temperature will exceed 1.5°C by 2027.
GHG emissions are still hovering around 40 gigatonnes of CO2 per annum. This means that every 25 years, global warming will increase by 0.5°C – putting the world on track to exceed 2°C by 2050 without significant action by policymakers and corporates. Despite urgent need, there is very little evidence to suggest that GHG emissions are being meaningfully reduced.
GHG emissions did fall by 4.6% in 2020 amid Covid-19 lockdowns that restricted travel and economic activity, which many hoped would serve as the catalyst for further reductions year-on-year. However, when the world came back online, GHG emissions rebounded 6.4% to a new record, eclipsing the pre-pandemic peak.
“The harsh reality is that emissions are continuing to rise,” says Philipponnat, adding that much of the discussion among policymakers has centred around reducing the CO2 intensity of our global economy. “That is a simply a sideshow”, he adds.
“Absolute emissions are what matters,” says Philipponnat. “Global warming is not driven by the CO2 intensity of our economies, but by the total GHG emissions.
“I hate to paint a relatively bleak picture, but it’s challenging to see it differently.”
Breaking with tradition
Finance Watch’s latest report, released this week, underscores the stark reality of rising climate risks and calls for economic models that do not mislead, scenario analyses that prepare the market, and a new prudential tool to address the build-up of systemic climate risk.
In a dire warning issued by climate scientists on the Intergovernmental Panel on Climate Change (IPCC), the world has been put on notice about the looming threat of climate tipping points, which could trigger devastating consequences as global temperatures rise to around 2°C and escalate to catastrophic levels beyond 3°C.
The impact is projected to be felt acutely by more than three billion people inhabiting regions highly susceptible to the adverse effects of climate change.
As these perilous climate projections unfold, one might expect an inevitable upheaval in the global economy. However, current evaluations of climate change’s economic impact paint a somewhat muted impact.
Finance Watch’s report notes how the Network for Greening the Financial System (NGFS) employs a methodology that suggests even a 3.5°C increase in the global mean surface temperature by the close of this century would prompt only a 7-14% decline in global economic output. Similarly, a 2020 report by the Financial Stability Board (FSB) anticipated that a 4°C temperature hike would result in a reduction of asset values ranging between 3-10%.
This curious conundrum arises, according Philipponnat, from the fact that economists are applying traditional financial risk models to evaluate climate risk, a practice that may not fully encapsulate the unprecedented challenges presented by the changing climate.
When asked why economists are failing to re-evaluate their approach to modelling climate-related risks, Philipponnat says that it’s due to a mixture of difficulties in breaking old habits and uncertainty over so-called ‘Green Swan’ events – a concept used to highly impactful and potentially financial disruptive events related to climate change or environmental issues which we know with certainty will occur with greater frequency in the future.
“Let’s bear in mind that the definition of a green swan event is that, contrary to a normal financial event, it is not probable; it’s certain it is happening,” he says, noting that the only uncertain or unqualified element is its rate of acceleration.
The impact of green swans on financial stability was explored in a paper published by the Bank for International Settlements in 2020. The paper explained that “traditional backward-looking risk assessments” could not accurately anticipate climate-related risks, including green swans. In response, it recommended not only the development of forward-looking scenario-based analysis but also for central banks but also play an active coordinating role in formulating and promoting mitigating measures such as carbon pricing.
The concept of a green swan is interesting, because it rules out the question of probability, says Philipponnat.
“You can forget about all your log-normal or other probability distribution logic; that’s not the way it’s happening.”
In defence of the those attempting to model climate scenarios, Philipponnat acknowledges that it’s incredibly difficult to change well-established ways of working, especially with the politics within economic institutions that are predisposed to stick to tradition.
An end to underestimates
According to Philipponnat, economists analysing the impact of climate change “must not be complicit, even if unwillingly, in the inaction of policymakers”.
“Producing biased analyses that underestimate future costs is no longer an option. Adapt economic models or they’ll undermine both climate change mitigation and adaptation,” he says.
For economic analyses to yield meaningful results, another important mentality shift needs to happen around timescale. In its report, Finance Watch underscores this point with reference to the one-off scenario exercise to be completed by the European Supervisory Authorities (ESAs), the European Central Bank (ECB) and the European Systemic Risk Board (ESRB) by 2025 at the request of the European Commission.
The purpose is to evaluate the impact of climate change on the financial system. Philipponnat is quick to commend the Commission for taking on this “vital task” but emphasises the importance of conducting the assessment “realistically” and in a “thorough and serious manner”.
To be useful, he says, two conditions must be met, namely that realistic modelling techniques are employed, and an extended time horizon is applied.
“It is essential to avoid the scenario where one claims to have carried out a comprehensive assessment, but the outcome is essentially non-informative,” he says.
Currently, the time horizon for the exercise is set for 2030, however, Philipponnat notes that it is widely agreed among economists that the significant impact of climate change on GDP will not become apparent by that date.
The effects are expected to manifest around 2050 and accelerate between 2060 and 2080, he says, adding that the primary sources of this economic impact are the effects on GDP and the issue of fossil fuels becoming stranded assets.
However, the geopolitical situation in the world suggests that fossil fuels are unlikely to become stranded in the next five to six years, even though the chances increase when looking 20, 30 or 40 years ahead.
“The only thing worse than not conducting the exercise would be to perform it and derive non-meaningful and benign results that might lead to inaction, leaving policymakers to believe that no significant issues have been identified.”
Cost of inaction
The Global Stocktake process at COP28 is the first official assessment of the commitments made by countries under the Paris Agreement and determine whether they are sufficient. Based on the UNFCCC’s latest synthesis and technical reports published earlier this year, existing policies to tackle climate change are well and truly off track.
“Once the cost of inaction is correctly assessed, the consequences in terms of decision-making will hopefully follow,” says Philipponnat, noting that approximately 60% of the investments required to mitigate climate change are not financially viable or “bankable”.
“Estimating properly the cost of inaction is a prerequisite to deciding to act.”
In simple terms, he says, these investments do not yield the returns on investment that private capital seeks, adding that this fact implies that private money will not flow into these endeavours, as they lack profitability.
Consequently, it becomes apparent that public funding and monitoring are necessary, he says, noting that while the common rhetoric often revolves around the idea that there is a lack of funding, this perception may change when one comprehends the true, substantial cost of not taking action.
“The necessary financial resources are more likely to be found because the survival of our societies is at stake,” he says.
“This realisation will exert indirect pressure on policymakers. Despite the challenges, there is still optimism that policymakers will confront the undeniable reality and take action.
“They must invest in the required infrastructures and the necessary transformations in our economies.”