In financial services considerable effort has been expended on developing climate-change scenario analysis and producing Task Force on Climate-Related Financial Disclosures (TCFD) results. This is an incredibly important, complex and difficult undertaking, and the many pioneers who have accelerated this should be congratulated, along with the regulators who have helped to drive uptake – it’s a huge step forward for financial services in a short space of time.
However, using actuarial principles to examine current climate-change scenario analysis limitations and assumptions yields a number of worrying observations, according to research from the Institute and Faculty of Actuaries (IFA) at the University of Exeter. These include:
- Many current climate-change scenario models are understating risk, showing benign, or even positive, economic impacts from a hot-house world in which we fail to limit global warming
- There is considerable uncertainty around how much and how quickly we expect the climate to warm – we may have seriously underestimated the pace of climate change
- This translates to uncertainty in carbon budgets, with a real chance that the carbon budgets for 1.5°C of warming are now negative
- This points to the importance of users of scenario analysis in financial services understanding these limitations and assumptions, and the responsibility to create more realistic models and craft detailed qualitative scenarios
- This underlines the need to race to net zero – with an intentional focus on accelerating a range of positive tipping points in socio-economic systems that we can control.
Climate-change modelling is complicated and at the root of these problems is a disconnect between climate scientists, economists and model users in financial services. In particular, science and risk which speak different languages. We could characterise this as:
- Scientists use evidence to prove theories, so would not typically say there is an iceberg until they are fully confident there is one present
- Risk managers use their imagination to think about what could go wrong. There could be an iceberg so we should typically steer well clear of it.
