The IFoA’s report ‘Climate Scorpion: the sting is in the tail’ highlighted not only the tail risks but the potential for positive tipping points – acceleration of positive trends. But it’s important not to be overly optimistic about our prospects.
Past Sustainability Board chairs Nick Spencer and Sandy Trust asked leading academics Laurie Laybourne and Ben Shread-Hewitt at the Strategic Climate Risks Initiative to outline ‘derailment risk’. What if the physical impacts of climate change do not accelerate our progress to a low-carbon, stable climate future, but act as a barrier against it?
This is an important ‘third rail’ that actuaries should be aware of in their policy and future pathway projections.
For over a year, Zambia has been suffering its worst drought in a century. In a climate-changed world, this story is as familiar as it is tragic. Yet there is a new dynamic emerging in Zambia with ominous implications for how the world hopes to navigate the climate threat.
The vast costs of the drought are threatening Zambia with what economists call the ‘climate-sovereign debt doom loop’. Half the country’s crops have been lost, leading to a surge in expensive food imports. Rivers and lakes are dry, stalling hydropower plants and triggering blackouts. Government spending is being diverted into crisis response but tax revenue is also falling as the economy slows, depleting already stretched government budgets. Meanwhile, external investors are increasing risk premiums, adding to the cost of borrowing.
Altogether, fiscal space is dramatically reduced. This can crowd out investment in climate resilience, making countries more vulnerable to the next disaster. A doom loop.
In the climate risk framework established by central banks, we can see this as a particularly challenging manifestation of physical risk. Climate shocks create costs, which tighten fiscal constraints, leading to a greater overall impact. By exposing another dimension to the climate threat, the ‘climate-sovereign debt doom loop’ is more reason for rapid climate action. Yet there is something more fundamental going on. This loop also shows that our ability to act might be threatened by climate change.
We call this ‘derailment risk’: the potential for the consequences of climate change to frustrate the ability of societies to respond to its causes and impacts. It is a third category of risk, alongside the physical risks and transition risks identified by central banks. Derailment risk emerges when physical and/or transition risks manifest and, in doing so, impact the ability to mitigate these risks. The ‘climate-sovereign debt doom loop’ is one example. Another is how inflation – driven by climate impacts or poorly executed transition policies – can trigger higher interest rates. High interest rates in turn disproportionately impact renewables and so could slow the transition from fossil fuels.
Derailment risk matters for financial markets. A reduction in decarbonisation and adaptation would increase physical risk as climate hazards and vulnerability would grow. And it would increase transition risk as firms would face the legal and reputational consequences of falling behind the climate curve.
More broadly, derailment risk means climate risks could be far greater than anticipated. While current climate policy pledges could lead to less warming than was expected prior to those commitments, the ability to deliver these pledges could be eroded. This means higher warming – and far higher physical and transition risks – cannot be discounted.
In response, financial institutions should engage with derailment risk as an important category of strategic risk in a climate-changing world. In doing so, they should explore how it can be included in risk assessments, which as the IFoA has made clear, needs dramatic improvement. The imminent overshoot of the 1.5C warming limit underlines this imperative.
Laurie Laybourn is executive director of the Strategic Climate Risks Initiative and an associate fellow at Chatham House.
Ben Shread-Hewitt is a researcher at the Strategic Climate Risks Initiative.
