Meet the new climate risk model – looks a lot like the DICEY old model?

November 16, 2023|Written by Joel Benjamin

It’s been nearly 10 years since former Bank of England Governor Mark Carney’s landmark 2015 Tragedy of the Horizon speech highlighting the future financial costs of climate change, where he noted that “once climate change becomes a defining issue for financial stability, it may already be too late”.

Yet annual greenhouse gas emissions since the Paris Agreement have continued to grow. Central bankers are now hiking base interest rates, under the guise of fighting inflation – which has made investments in urgently needed clean infrastructure significantly less affordable, just when annual investment in clean energy needs to increase 300% this decade to hit climate targets.

The latest UNEP Production Gap report warns current fossil fuel investment plans would lead to 460% more coal production, 83% more gas, and 29% more oil in 2030 than is needed, if global temperature rise  is to be kept at the internationally agreed 1.5C.

Several large diggers and trucks in an open coal mine
© Dominik Vanyi

In July the Institute and Faculty of Actuaries warned that “ongoing investments into fossil fuel infrastructure will bring increased emissions, which will accelerate warming”. 

Insurance leaders have unequivocally stated that if climate change raises average temperatures to 4˚C above pre-industrial levels, most assets will be uninsurable.

Yet the latest research from Insure Our Future finds Lloyd’s of London insurers continue to dominate underwriting of fossil fuel projects, despite such warnings, with natural catastrophe payouts doubling since 2017.

The Central Banks and Supervisors Network for Greening the Financial System (NGFS) recently updated its climate scenarios, adding one in which warming hits 2.3°C due to countries with net zero targets not taking sufficient action and dropping a 1.5°C-aligned model.

The NGFS dropped the ‘Divergent Net Zero’ scenario under which warming was limited to 1.5°C, “given the reduced likelihood of a successful uncoordinated transition”. Under this “disorderly” scenario, net-zero greenhouse gas emissions were achieved by 2050 but with higher costs due to divergent policies introduced across sectors and a quicker phase out of fossil fuels – which as evidenced by the Production Gap report – is simply not happening.

Should we be asking ourselves why the financial sector fails to heed its own warnings?

The disconnect between financial models and science 

Albert Einstein once observed: “We cannot solve our problems with the same level of thinking that created them”. So it holds for investment consultants that attempt to model the future impacts of climate change on the financial sector while assuming – based on the work of mainstream economists – that historical levels of economic growth will continue largely unchecked, even as climate breakdown accelerates.  

At root, this flawed mainstream economic thinking is drawn from the likes of William Nordhaus, recipient of “energy economist of the year” award at the 2023 Energy Intelligence Forum (previously known as Oil & Money).  Perhaps unsurprising, the oil industry prefers economic thinking that assumes the world can carry on with economic growth whilst suffering climate catastrophe. 

 In July, Carbon Tracker published Loading the DICE against pensions by University College London professor Steve Keen pointing to the failings of academic thought on the economic damages from climate change which have, via critical failures of the peer review process, impaired an understanding of the financial risk models of investment consultants, market participants, central banks and regulators.

In the weeks following publication, investment consultant Mercer, whose climate scenario analysis was critiqued in the report, challenged the conclusions by arguing that Carbon Tracker’s analysis focussed on an ‘old’ scenario analysis model – which Mercer have since updated.  And further, that Carbon Tracker didn’t analyse all of Mercer’s climate related advice and outputs, so in their view it is an “incomplete assessment” and therefore “misleading.”

Mercer did indeed update their scenario models in 2019, with aid from Cambridge Econometrics and Ortec Finance, partly in response to concerns it downplayed climate risks. But the other points ignore the thrust of Keen’s paper, namely that the economic assumptions and inputs regarding the physical impacts of climate change, and therefore the economic damage estimates, remain largely unchanged, resulting in surprisingly low physical climate damage estimates.

In November 2012, a riverside pub in York was flooded for the second time in eight weeks (c) Ian S
(c) Ian S

In short, it is not Mercer’s model, it’s the academic inputs, derived from mainstream economic thinking at the heart of the problem. 

Mercer has instead ignored the main thrust of Keen’s report, that the empirical assumptions made by economists are ignorant of what climate change actually means.

It is the empirical assumptions underlying the models that make them so dangerous, and unless Mercer’s new model uses entirely different empirical assumptions, then it will be as dangerous a guide to the risks global warming poses to pension funds as was their old model,” Keen said.

The lack of improved economic assumptions is evident in the model outputs. Below, we reproduce Figure 1 from the report demonstrating Shropshire’s Climate Scenario Analysis output – produced by Mercer in 2020 – the first year Shropshire and LGPS Central undertook TCFD climate risk analysis, after Mercer’s “old” model was said to be updated in 2019.

The most recent 2022 output from Shropshire LGPS does show a more significant jump in damages, (changes were made to increase damages in the model) – increasing to 1% losses per year in 2064, but the outputs are not directly compatible with the 2020 version –- due to the reference date extending from 2050 (30 years) to 2062 (40 years). 

While a 1% reduction per year impact in portfolio returns is significant, it’s well below the 3% to 7% per annum annual growth rate typically achieved by share indices, meaning in economists’ and investment consultants’ views, growth will still occur, and returns will still be positive, just by less than in the complete absence of climate change. 

Fundamentally, this represents continued use of the same flawed economic literature being incorporated into Mercer’s modelling, resulting in advice that economic growth and fund returns will remain positive, even in a failed transition scenario at 4C. 

If there were further updates to consultants models, we’re unlikely to know much about them, because Mercer, along with other investment consultants, implored Local Government Pensions Scheme (LGPS) clients to withhold their models, scenario outputs & climate risk advice from public disclosure under Freedom of Information Act (FOIA) requests – so Carbon Tracker were unable to analyse much of their work. 

What now?

Scientists are agreed that rapid action to drive down emissions now will be substantially cheaper than delayed action to reduce emissions in the future.  Models which trivialize the real-world impact of climate change may have the opposite effect.  

The need for alternative modelling approaches is what drove scientist Tim Lenton at Exeter University to develop what he terms “decision useful” climate scenario models – providing the USS pension scheme with a richer narrative scenario, which has been shaped by sociologists, climate & policy experts – not just by mainstream economists. 

We remain hopeful, given public comments made by The Pensions Regulator (TPR) that key actors in the financial space recognize the deficiencies of current advice being offered to pension funds and investors, and are actively exploring alternatives. 

Indeed, the TPR has called on pension fund trustees to make climate scenario analysis “useful” and for a “revolution” in how modelling is undertaken.  The TPR “recognises and shares” concerns that some climate scenarios may show impacts that seem at odds with established science, after research raised concerns that “flawed” climate analysis could be placing pension savers at risk. 

Such changes would benefit investors, regulators and central banks by providing more realistic climate risk scenarios that more fairly balance the short-term costs of a rapid and successful transition, against the enormous mid to longer term benefits of ensuring a stable and liveable climate – avoiding the worst of climate damages.

The gap between the outputs of climate models commonly used in the financial sector and what climate scientists say is happening needs to be urgently reconciled. We don’t have the luxury of another credit cycle to ensure climate alignment of financial policy frameworks and mandates.

I encourage anyone concerned by the influence of mainstream economics on climate risk analysis to join Green Central Banking and the Climate Safe Lending Network on 22 November for a panel discussion on the problems with climate risk scenarios and how to fix them. Featuring professor Steve Keen, political economist Ann Pettifor, Tipping Frontier co-founder Sahil Shah, investment consultant Sanjay Joshi, and moderated by Boston University School of Law professor Madison Condon. 

This is an edited version of an article that first appeared on Carbon Tracker.

This page was last updated November 22, 2023

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