Climate-Related Financial Policy in a World of Radical Uncertainty

The policy agenda for dealing with climate-related financial risks has focused largely on conventional market-based solutions. This emphasises information gaps that prevent accurate climate risk assessment and assumes that these gaps can be filled using disclosure, scenario analysis and stress testing, thus allowing markets to self-correct. From this perspective, the solution is simply better information.

However, this working paper from the Institute for Innovation and Public Purpose at University College London argues that this information gap approach is misguided. It suggests that ‘efficient’ price discovery is not possible because of the radical uncertainty associated with climate change.

Conventional understandings of risk imply random outcomes with knowable probabilities. This is different from uncertainty, in which there is no basis upon which to form any calculable probability. In essence, this paper argues that climate risk is unknowable and therefore unpriceable.

As an alternative to this flawed information gap and market-based policy agenda, the paper proposes a precautionary financial policy (PFP) approach. This is based on the well-established concept of the precautionary principle in the face of catastrophic danger. 

Following an overview of the precautionary principle as it relates to environmental protection, the paper outlines how central banks can actively steer market actors away from carbon and integrate PFP into macroprudential and monetary policy.

While scenario analysis and stress testing recognise the uncertainty problem to some extent, the paper suggests that “conventional backwards-looking probabilistic financial risk modelling is not fit for purpose in dealing with climate-related financial risks.” 

In contrast, the PFP approach helps justify immediate preventative actions to mitigate the potentially catastrophic financial, economic and social consequences of climate change. This can be done while directing financial markets towards alignment with the Paris agreement targets and a net-zero carbon future.