Report: financial models fail to capture reality of climate risks

New research finds financial institutions lack a comprehensive understanding of the models they use to forecast the economic impact of climate change. The study revealed institutions are underestimating the risks associated with temperature rises.

Numerous “implausible” outcomes were generated by the models, highlighting a significant “disconnect” between climate scientists, economists, model developers, and the financial institutions employing these models, a report by the Institute and Faculty of Actuaries and the University of Exeter finds.

The study reports that certain models may have “limited use as they do not adequately communicate the level of risk we are likely to face if we fail to decarbonise quickly enough”. Additionally, critical factors are sometimes omitted from the models. For instance, the Network for Greening the Financial System evaluated the global gross domestic product loss in a “hothouse” world with temperatures 3°C higher but neglected to consider the impacts related to extreme weather, sea-level rise, or broader societal effects stemming from migration or conflict.

Consequently, the researchers argue that some financial institutions using these overly optimistic models have incorrectly reported minimal economic consequences if global warming surpassed 1.5°C above pre-industrial levels. According to the UN’s scientific body, the Paris Agreement commits countries to limit warming to 1.5°C by 2100; however, existing policies are projected to result in a rise between 2.4°C and 2.6°C.

The researchers reveal that several prominent UK financial institutions, as indicated in Task Force on Climate-Related Financial Disclosures reports, claim they will fare equally well or even better in a “hothouse” scenario compared to more moderate warming scenarios. However, the report did not specify the names of these institutions. The study’s co-author, Tim Lenton, who holds the chair in climate change at Exeter, said that some economists predict “relatively low economic damage” from high levels of warming.

Warnings of extrapolating results from economic studies are not new. At the recent Green Swan conference, John Hassler, professor of economics at Stockholm University, referenced a 2015 paper that implies Sweden would gain over 500% of GDP if global warming stood at 2.5ºC at the end of the century, an implication that “of course, makes absolutely no sense”.

Moreover, the researchers highlighted that models often failed to capture the consequences of surpassing critical climate tipping points – irreversible negative changes that trigger further effects. The report notes that “there is a possibility that the remaining carbon budget for limiting warming to 1.5ºC is already zero”. They also said that financial institutions frequently lacked an understanding of the underlying assumptions and limitations embedded within the models.

As companies are increasingly required to disclose climate-related risks, they rely on mathematical models to assess the resilience of their assets and businesses under different warming scenarios. To address this issue, the International Sustainability Standards Board (ISSB) recently released guidelines aimed at assisting companies in informing investors about sustainability-related risks, including the climate scenarios used in their calculations.

The ISSB guidelines are intended to provide a global baseline, and countries like the UK and Japan have expressed their intention to incorporate these standards into their reporting regulations. Starting in 2024, companies will need to report complete emissions, including those from their supply chains in the second year of reporting. However, gathering such data from all suppliers presents a significant challenge.