Central bankers still fail to account for climate tipping points, experts say

A new report shows that the world has breached a climate tipping point, with global warming set to reach at least 1.5ºC. Experts say that while some financial regulators might be aware of the risk of tipping points, beyond which changes become irreversible, most climate economists are not adequately accounting for these risks.

“The global tipping points report should be the wake-up call for any governments that have accepted the advice of economists thus far. The trouble is that most of those government departments don’t realise that economists are assuming there will be no tipping points,” said Steve Keen, an economist and honorary professor at University College London.

The second global tipping point report from the University of Exeter finds that coral reefs have reached a tipping point, with more than 80% of reefs affected by extreme ocean temperatures and many now face long-term decline.

The study from over a hundred researchers found that other tipping points could be around the corner if global warming is not checked, including the loss of the Amazon rainforest, the collapse of ocean currents and ice sheets melting.

While climate change is gradual, a tipping point is usually an abrupt change to the Earth’s ecosystem which could trigger further risks, both from physical climate and environmental impacts and from economic risks.

Regulators “should prioritise tipping points because they represent a fundamental threat to financial stability that falls squarely within their core mandate”, said Jesse Abrams, senior impact fellow at Green Futures Solutions at the University of Exeter.

Economic uncertainty from tipping points

Economies are embedded within natural ecosystems and a “breakdown comes with major ramifications, including for central banks’ core mandates”, said Lydia Marsden, a research fellow in sustainable finance at University College London’s Institute for Innovation and Public Purpose who has worked on how central banks can incorporate nature risk into their policies.

One of the biggest concerns is about the possible collapse of the Atlantic Meridional Overturning Circulation (Amoc), an ocean current that maintains Europe’s temperate climate. If the Amoc were to collapse, one study shows it would cause a drop in rainfall and farming would cease without technological intervention, impacting food prices and increasing inflation.

“At a minimum, central banks and supervisors need to be monitoring the latest developments in the science around the dynamics and consequences of these threats – not least because the integrated assessment models that are more familiar to these policymakers currently vastly understate the risks of tipping points in the climate system and ecosystem services,” said Marsden.

Traditional economic models and risk management generally assume predictable changes based on historical data. But climate change, and particularly tipping points, are unprecedented. If breached, tipping points could create shocks that would overwhelm financial systems, the report warns.

“Central banks learned from 2008 that systemic risks require proactive intervention before crisis strikes. The same logic applies here, but with even less ability to reverse course once thresholds are crossed,” said Abrams.

Difference in economic and climate scientific models

Tipping points could increase climate volatility in the run-up to such events occurring, said Jean-Francois Mercure, director of climate policy at the University of Exeter

“In those conditions, the volatility will find its way into financial systems. This means that systems ‘anticipate’ tipping points well ahead of experiencing them. We could see food price instability occur in anticipation of a tipping point, because climate variables are becoming unstable,” he said.

European Central Bank president Christine Lagarde has noted the risks of climate tipping points, while research from other central banks and the Network for Greening the Financial System has also said that tipping points are a concern. But so far, there are concerns that central bank economists are not taking tipping points into account in their research.

Most central banks in high-income countries tend to focus on disclosures and stress testing, said Marsden. But they do not “capture the economic and financial consequences of tipping points, largely because they rely on scenarios that either don’t include these dynamics or greatly underestimate them”.

Economists use various economic models such as Dice to predict the potential impact of climate change on the economy. These models make assumptions about temperature and GDP that are based on current data where temperature is the only factor of climate change, said Keen.

But climate scientists are warning that what we know about temperature and climate will completely flip if global warming continues. Instead, climate scientists use global circulation models which account for various changes besides temperature such as moisture content.

“There’s the gap between climate scientists and climate economists that is comparable with the gap between religious fundamentalists in the 15th century and physicists in the 20th century,” Keen said.

Closing the gap between economists and climate scientists

For Keen the solution to closing that gap is for central banks to do an audit of their research and identify to what extent it aligns with climate research. This will allow them to change the damage function that economists currently use, replacing it with a climate damage function based on scientific data.

“While it’s an important research exercise to improve modelling results, ultimately prudential and monetary policies need to start taking a more proactive approach,” said Marsden.

The financial sector might not have the incentive it needs to take extremes seriously, but now we know extremes like tipping points are happening and central bankers need to act, said Mercure

While some people feel these disasters are so great that no level of preparedness can be sufficient, “this is not a view that will be sustainable to maintain as we enter a new phase of climate change and low-carbon transition”.

Focusing on global average temperature is one symptom, as it avoids looking at tail risks, or rare and extreme market events, and this is driving the problem, said Mercure. But those tails are already here. In 2022, a flood in Pakistan wiped out one-third of its public finances which required it to take on more debt. Central banks need to use models “that understand fat tails and that tails are getting fatter rapidly, and how action on preparedness mitigates that tail fatness”.

“Central banks and the world of finance will have to learn to work with an unstable world – more conflict, more price instability, more pandemics, more natural disasters, more insolvencies, more inflation and so on,” said Mercure.

Update, 6 November: this article was corrected to say that just one climate tipping point, not “some”, have been breached.

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