New analysis from the Federal Reserve has identified a series of deep challenges for macroprudential climate analysis and attempts to model the financial and economic effects of climate change. The fundamental uncertainty and complexity involved in such modelling means that currently available results should be interpreted with caution, the research finds, emphasising that no methodology can be used in isolation to fully assess climate-related financial risks.
The paper, the latest from the Fed’s finance and economics discussion series, reviews potential financial system vulnerabilities of climate change and describes the major methodologies used to study them. It finds a variety of challenges, including long time horizons, embedding heterogeneity, reliance on unknown innovation and deviations from standard assumptions. No single methodology can address all of these challenges, say the authors, arguing instead for a combined approach.
“While some models are beginning to apply more realistic assumptions and distributions, there is a large gulf between the promise and the current state of these models,” the paper says. “We are closer to the beginning than the end of integrating climate-related risks and financial system vulnerabilities in modelling,” it concludes, calling the field “a wide-open topic for interested researchers”.
Challenges facing the modelling of climate risk was also a key theme in a recent speech by economist Anil Kashyap reviewing the results of last year’s climate stress test of the UK’s largest banks and insurers. Kashyap, an external member of the Bank of England’s financial policy committee and a consultant for the Fed, warned that climate risk was already a big risk management problem for financial institutions. Modelling is typically uneven inside each firm, he said, with substantial variation in how different parts of the organisation modelled things.
All participants in the stress test relied on third-party consultants to assist in at least some aspects of their climate modelling, Kashyap said, allowing that it will take time for financial services firms to hire new staff and build their own competence. He also said that some of the more complex sector specific models used by financial institutions made simplifying assumptions which were not always consistent with the scenarios provided.
Kashyap expects that improvements to climate risk modelling by banks and insurers will be incremental. The Bank of England is meeting with the participants in the stress testing exercise to discuss and share best practices, he said, and the findings from this engagement will be made available to the broader financial sector.
This page was last updated July 25, 2022
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