Warning – the Earth’s climate may be more sensitive than we thought, meaning we are underestimating the risks from climate change – reinforcing the need to race to zero.
“Everyone who cares about financial stability should read this paper” Nigel Topping, UK Climate Action Champion for COP26.
In financial services considerable effort has been expended on developing climate-change scenario analysis and producing TCFD results. This is an incredibly important, complex and difficult undertaking, and the many pioneers who have accelerated this should be congratulated, along with the regulators who have helped to drive uptake – it’s a huge step forward for financial services in a short space of time.
However, using actuarial principles to examine current climate-change scenario analysis limitations and assumptions yields a number of worrying observations, including:
Climate-change modelling is complicated and at the root of these problems is a disconnect between climate scientists, economists and model users in financial services. In particular, science and risk which speak different languages. We could characterise this as:
A simple analogy is the Titanic. Looking backwards from the peaceful aft deck of the Titanic on the afternoon of 14 April 1912, you might reasonably predict a smooth passage to New York; there is no evidence to suggest things might go wrong. A risk-management mindset would pay more attention to warnings of icebergs and take action, such as posting more lookouts, changing course or reducing speed. The Emperor’s New
Climate Scenarios shows that some of the climate modelling undertaken is backward-looking, and as such simply excludes many of the risks we expect to face.
Typically, firms consider three scenarios: an orderly transition where we limit global warming in an organised way, a disorderly transition where we limit global warming but it’s more chaotic, and a ‘hot-house’ world where we don’t limit global warming at all. Recall that scientists have questioned whether we could successfully adapt to a hot-house world in which we would experience rising combinations of risks such as sea-level rise, storms, floods, crop failures, droughts and heat stress, leading to involuntary mass migrations.
A brief examination of financial services TCFD results shows some surprises. These three scenarios are very different conceptually, so it seems odd that they would produce remarkably similar results. As seen in the table below, the hot-house world doesn’t look so bad – in fact, one institution shows it to be slightly economically positive compared to transitioning – a result that is patently incorrect and at odds with climate science.
|
Institution |
Orderly |
Disorderly |
Hot House |
|
Institution 1 |
-0.2% |
-0.2% |
-0.1% |
|
Institution 2 |
-0.1% |
|
-0.1% |
|
Institution 3 |
-0.1% |
|
-1.0% |
|
Institution 4 |
0.7% |
|
-0.5% |
|
Institution 5 |
-0.1% |
-0.5% |
-0.4% |
|
Institution 6 |
0.0% |
|
-0.2% |
To answer the question ‘Why are the hot-house world results so wrong’, we apply actuarial principles to climate change and its modelling.
Simplifying to calculate the economic impact of a climate scenario, we need to estimate three things:
Our current emissions are tracking the hot-house world scenario. Climate change is happening more quickly than expected. Continuing to be surprised implies our assumptions around how quickly the planet will warm are wrong, we may have underestimated climate change. In actuarial terms, we are not using experience analysis to adjust our basis.
The key assumption here as to how much the planet will warm is a concept known as equilibrium climate sensitivity (ECS), which is defined as the level of warming we expect when we double atmospheric greenhouse gases – something we have now achieved.
ECS is estimated to be 3°C, which you could interpret as ‘if we stopped everything today and let the climate warm it would eventually get to 3°C of warming based on the current stock of GHGs in the atmosphere’. But the Earth’s climate system is a complex beast, there is a wide range, meaning it could be anything from 2.5°C to 4°C. ECS is long tailed – there is an 18% chance ECS is greater than 4.5°C. So an 18% chance we might reach 4.5°C of warming or more at current levels of GHGs, which is profoundly unsettling.
To be clear, this isn’t a prediction, but it is something we should consider carefully as a high impact tail risk from a risk-management perspective.
The implications on carbon budgets are also profound. Given the uncertainty around how much the Earth may warm for a given level of GHGs, there is also a high level of uncertainty around carbon budgets. In fact, many commonly used net-zero carbon budgets have an error range of over 100%. This means there is every chance the carbon budget for 1.5°C of warming may now be negative.
The next question we need to answer is what the impact might be and why the models show a trivial impact. Some economists have estimated negative GDP impact at 3°C of warming to be around 2% of GDP – in stark contrast to scientists’ warnings. This is because they have assumed sectors of the economy that work indoors can be excluded from any calculations and that the future will be like the past – people will work a bit less when its warmer, as they have in the past. Unfortunately, this excludes most of the economy from consideration, as well as most of the risks we expect to face.
An alternative approach that would yield more realistic results would be to adopt a reverse stress testing approach that recognises the practical limits to adapting successfully to a hot-house world. Such an approach would show significant GDP losses starting to occur between 2°C and 3°C, which would be more realistic and should spur more effort on decarbonisation to avoid these losses, a concept we explore further in The Emperor’s
While this paper airs some profound challenges around our current approach to climate change scenario analysis and net zero, it is key to remember that we have agency here. Another analogy is to think of the Earth as an electric oven and the level of GHGs in the atmosphere as the temperature setting. If we increase GHG levels, we are turning up the temperature, but it takes time for the oven to come up to temperature.
This means we are not yet locked into a hot-house world future, provided we take action to reduce emissions, remove GHGs from the atmosphere and repair broken parts of the climate system.
As actuaries we have enormous influence in the global capital and insurance markets, which will be essential for accelerating a range of positive socio-economic tipping points in human societies that can propel rapid decarbonisation, in areas including transportation, agriculture, ecosystem regeneration, politics and public opinion. We must now consciously and intentionally use that influence to inform more realistic and decision-useful scenario analysis, but also to drive capital allocation and insurance development that accelerates decarbonisation.
Time to post more lookouts, reduce speed and take action to avoid the iceberg.
