A groundswell of concern is building around the soundness of economic research used to underpin climate-related risk and investment models.
A growing number of voices warn that the economic assumptions of climate risk management are misaligned with science and underestimating financial damages, with Carbon Tracker claiming that UK pension funds use flawed investment models, potentially putting retirement savings at risk.
In new report, Loading the DICE against pension funds, the independent financial think tank found that there is a “huge disconnect” between what scientists expect from global warming, and what pensioners, investors and financial systems are prepared for.
According to the study, UK pension funds use investment models based on economic research that predict global warming of 2°C to 4.3°C will have only a minimal impact on member portfolios. However, climate science finds such temperature rises could trigger dangerous tipping points and in the worst-case scenario represent an existential threat.
Minsky moment
Carbon Tracker warned that as a result a wealth-damaging correction or ‘Minsky moment’ – whereby a sudden decline in market sentiment leads to a market crash – was virtually inevitable.
Creon Butler, Director, Global Economy and Finance Programme at think tank Chatham House, made a similar warning of a “probable sharp adjustment” this month, saying that “financial markets did not yet reflect climate risk”, despite the clear severe economic and financial consequences of climate change.
Butler said there were a number of reasons for financial markets’ apparent lack of concern, including the view that rapid technological development would solve the problem of climate change and that it was a medium- to long-term risk. He also noted that even with the belief that a large, climate-related price adjustment will happen, it is risky for an individual investor, who doesn’t know when it exactly will happen, to take a position.
Butler said it was striking that these factors were still so significant despite significant efforts to sensitise financial institutions to understand, measure and be transparent about climate-related risk in their portfolios ever since former Governor of the Bank of England Mark Carney’s ‘Tragedy of the Horizons’ speech at Lloyd’s of London eight years ago.
“The far-sighted amongst you are anticipating broader global impacts on property, migration and political stability, as well as food and water security,” Carney said at the time. “So why isn’t more being done to address it?”
Flawed scenarios
The Institute and Faculty of Actuaries (IFoA) also warned that economic models currently used to underpin climate scenario modelling by financial institutions often fail to adequately reflect the magnitude of the threat to the planet and society.
It found existing scenarios omit crucial factors such as sea level rise, heat stress, climate tipping points, civil unrest, and involuntary mass migration, all of which could have severe economic implications.
Author of the report Professor Tim Lenton said: “It is essential that financial services institutions and regulators move towards realistic climate scenarios that recognise the potentially catastrophic risks posed by climate change.”
In February, ESG Investor reported on the limitations of climate scenarios issued by financial regulators and central banks.
Some actuaries are arguing that “narrative scenarios” – qualitative information to accompany the quantitative data to provide context around climate-related metrics – would help. The Real World Climate Scenarios initiative aims to address the issue by developing more relevant scenarios that integrate the complex the overlapping impacts such as geopolitical, extreme weather events, migration and stranded assets, among others. Carbon Tracker’s report also found faults in central banks and regulators’ scenarios, noting that they relied on economic literature that did not provide realistic estimates of the economic damages from climate change.
Operating in silos
Speaking to ESG Investor, Professor Steve Keen, author of the Carbon Tracker report, said an issue was that the disciplines of science and economics operated in silos, and fail to interact with each other.
“It’s partly respect and its partly snobbery,” he said. ”Physics will think that is better than other disciplines, and not understand why it should read about another discipline – economics is exactly the same.”
He said most scientists wouldn’t know what economists were doing in places like the Intergovernmental Panel on Climate Change’s (IPCC), and on climate change in general as they “simply don’t read them”. However, there are exceptions to the rule, he said, such as Professor Lenton, who had been “horrified” by climate economic papers he had read.
Carbon Tracker’s report noted that the economics of climate change is an interdisciplinary subject, but papers on the associated damages are usually refereed by economists alone.
Properly refereeing these papers requires knowledge of the science of global warming that economists typically did not have, according to the report. Consequently, economic referees approved the publication of papers that made claims about global warming that are seriously at odds with scientific literature.
While climate scientists and some leading economists, such as Nicholas Stern and Joseph Stiglitz, have challenged the inadequate climate risk models used in economic reports, the majority of economists have not aligned their reports with climate science, it added.
