Approaches to climate scenario analysis are currently based on “implausible” assumptions that could delay action and create fiduciary duty challenges for investors, according to a new study by the Institute & Faculty of Actuaries.
Sandy Trust, head of organizational risk at M&G, a global investment manager headquartered in London, England and one of the authors of the study, says a growing number of investors — including pension funds — are required to produce climate scenario analyses to model how their financial performance might be affected by different future climate pathways.
However, the study contends that the underwhelming results of climate analysis come from the narrowness of the scenarios that are being tested, not the lack of financial risk posed by climate change.
For example, it claims an analysis by the Network for Greening the Financial System — a network of 114 central banks and financial supervisors that aims to accelerate the scaling up of green finance — on the impact of a hothouse world on global GDP didn’t include “impacts related to extreme weather, sea-level rise or wider societal impacts from migration or conflict.”
There’s a disconnect between interpretations of risk, says Trust. “If you look at risk in science and in financial services, they’re totally different things. Scientists are cautious about publishing their ideas if they can’t taste it, touch it, lick it or poke it.”
Financial risk management is the opposite. In part, this is due to a lack of knowledge on climate change in the financial services industry, she says, noting the industry doesn’t have the capability to conduct climate scenario analyses. “[The industry] lacks the expertise to actually dig into the right holes. So they all spend a lot of money on constructing expensive modelling infrastructure that have no practical value.”
Inevitably, the industry is putting too much focus on the financial implication of a warming planet, adds Trust. “If you’ve got the scientists screaming and pointing at disaster and then you get the best economists coming up with an estimate of two per cent GDP impact, that’s a problem because that means not much will happen.”
He says there’s a need for more realistic, catastrophic risk assessment to explore what sorts of things are likely to happen and the eventual impact. For example, heat stress creates water stress, which leads to population migration. “It’s the last risks and their connectivity that are going to determine the outcomes.”
There’s also a need for consistency, adds Trust, suggesting something similar to the accounting standards and noting this would have to be driven by regulators.
The study proposes a new methodology. Rather than looking at what has happened and trying to work out what’s going to happen, “we need to look at the loss of everything. We could argue all week about setting limits on global warming. There is a serious impact above 2°C and we can argue about the degrees. The whole point: this isn’t a thumbs up for what is acceptable, it is to accelerate action and, if you believe the risk is serious, taking action to avoid it.”
Actuaries have a role to play, he adds. They’re often in governance positions so they should be questioning, for example, the results of the task force on climate-related financial disclosures’ mandated scenario analysis. From the perspective of investment and pension decision-makers, they have a fiduciary responsibility to do so.
Ultimately, says Trust, this means actuaries should be investing in developing their skills around climate change and scenario modelling.