Finance, Climate Change and Radical Uncertainty: Towards a Precautionary Approach to Financial Policy

Climate-related financial risks (CRFR) are a rapidly emerging challenge for central banks and financial supervisors, but the radical uncertainty involved in climate change makes traditional data gathering and probabilistic modelling of little use in understanding this risk. That is the central argument put forward by this paper from University College London and the New Economics Foundation.

Considering the potentially catastrophic losses that may result from climate change, the authors propose stronger macroprudential regulatory interventions in accordance with the precautionary principle.

CRFR has largely been seen as a market flaw or failure in which climate risk is under-priced, and so the policy response has so far focused mainly on market-correcting strategies and especially on climate risk disclosure.

This disclosure is largely aligned with the recommendations of the Taskforce on Climate-related Financial Disclosures, including the use of scenario analysis and stress testing. However, the authors state that assumptions underlying scenario analysis are open to question, and the effects of stress testing results on policy interventions are minimal.

This lack of meaningful action is often blamed on a lack of data or ‘intellectual capacity’ to fully understand climate risk and how policy interventions might affect it. The paper challenges this assertion and argues that CRFR – especially short- to medium-term transition risks and long-term physical risks – are subject to radical or Knightian uncertainty whereby the probabilities of different outcomes are impossible to calculate. This means that there may never be sufficient ‘intellectual capacity’ for policy action.

In the face of such vast and unknowable climate risk, the authors propose, a precautionary, market-shaping approach to financial policy and supervision is required, rooted in the precautionary principle and in macroprudential policy.

Specific policy proposals suggested by the authors include the integration of climate risk into capital adequacy requirements, the climate-alignment of credit controls and credit guidance, and the integration of climate risk into monetary policy operations. The paper ends with suggestions for further research.