Financial services told to address climate model failures

Actuaries and scientists have urged financial services firms to revisit their models on climate change amid fears that the current model significantly underestimate the potential impacts.

The Institute and Faculty of Actuaries (IFoA) and the University of Exeter have published a new study which calls for a deeper understanding of climate change, including tipping points in order to improve financial services’ climate- scenario modelling.

The IFoA said scenario modelling remains an important component of the actuarial risk-management toolkit. In the context of climate change, scenario modelling enables financial institutions and regulators to investigate the impact of different climate futures, which is important given the challenges we face.

“In the paper we use actuarial principles to examine the limitations and assumptions in relation to climate-change scenario modelling practices in financial services, focusing on hot-house world scenarios of 3˚C or more of warming,” it added. “It demonstrates how current techniques exclude many of the most severe impacts we can expect from climate change, such as tipping points and second order impacts – they simply do not exist in the models meaning the models understate the level of risk.

“Our objective in writing this paper is to help accelerate the progress of more realistic scenario modelling, which we in turn hope will help to further accelerate the progress on decarbonisation we need.”

The report found:

  • Many climate-scenario models in financial services are significantly underestimating climate risk.
  • Carbon budgets may be smaller than anticipated and risks may develop more quickly.
  • Regulatory scenarios introduce consistency but also the risk of group think, with scenario analysis outcomes being taken too literally and out of context.
  • Education is needed on the assumptions underpinning the models and their limitations.
  • The development of realistic qualitative and quantitative climate scenarios is required.
  • Model development is required to better capture risk drivers, uncertainties and impacts.

Professor Tim Lenton, chair in Climate Change and Earth System Science at the University of Exeter warned the results of the report should act as a wake up call to the financial services sector.

“We have left it too late to tackle climate change incrementally. It now requires transformational change and a dramatic acceleration of progress,” He added. “A growing threat is the approach of ‘tipping points’, thresholds which, once crossed, trigger irreversible changes, such as the loss of the Amazon rainforest or the West Antarctic ice sheet.

“Some tipping point thresholds have already been reached, while others are getting closer as global warming continues. Once tipped into a new state, many of these systems will cause further warming, and may interact to form cascades that could threaten the existence of human civilisations.”

He added: “However, some economists have predicted that damages from global warming will be as low as 2% of global economic production for a 3˚C rise in global average surface temperature. Such low estimates of economic damages, combined with assumptions that human economic productivity will be an order of magnitude higher than today, contrast strongly with predictions made by scientists of significantly reduced human habitability from climate change.

“It is concerning to see these same economic models being used to underpin climate-change scenario analysis in financial services, leading to the publication of implausible results in the Task Force on Climate-related Financial Disclosures (TCFD) reporting that show benign, or even positive, economic outcomes in a hot-house world.”

Lenton explained this jars with climate science, which shows our economy may not exist at all if we do not mitigate climate change.

“It is essential that financial services institutions and regulators understand the limitations of these models and move towards realistic climate scenarios that recognise the catastrophic downside risk of a hot-house world,” he continued. “My hope is that this will spur a further acceleration of activity towards net zero in financial services, as it is only by reducing emissions, repairing the climate system and removing greenhouses gases that we will avoid the worst impacts of climate change – and we will need the support of the capital and insurance markets to achieve this.

“Actuaries have an important contribution to make here. The application of actuarial principles to climate-change scenario analysis demonstrates the significant weaknesses in current approaches. Actuaries also wield enormous influence in the global financial system.

“In addition to their role in the insurance markets, their work in pensions means they can impact capital allocation in long-term savings in a way few other professions can, the financial system is critical to accelerating a range of positive socio-economic tipping points. Because just as tipping points are part of the greatest threat we face, the same logic may also provide the solution.

“We have identified a variety of positive tipping points in human societies that can propel rapid decarbonisation, in areas including transportation, agriculture, ecosystem regeneration, politics and public opinion. This concept could unlock the stalemate, the sense that there’s nothing we can do about climate change.”