The Institute and Faculty of Actuaries (IFoA) wins climate risk research paper of the year for its report The Emperor's New Climate Scenarios – a warning for financial services.
Published in July 2023, and created in partnership with the University of Exeter, the report found economic models underpinning climate scenario modelling in financial services do not always reflect the threat climate change poses to our planet and society.
The study provided several reasons for limitations in commonly-used climate scenarios.
It explains there is considerable uncertainty in key climate-system modelling assumptions, yet no margins are currently included to represent this uncertainty. There is also limited consideration of higher warming scenarios, but models do not consider real-world impacts, such as tipping points, sea-level rises and involuntary mass migration.
The paper discusses carbon budgets – and the one-in-three chance that we may have already used up the carbon budget for limiting warming to 1.5°C. It also explores the level of warming to be expected when atmospheric greenhouse gases are doubled – and the 18% chance that this could be above 4.5°C.
InsuranceERM asked Sandy Trust, lead author of the report and a past chair of the IFoA Sustainability Board, why scenarios used by financial services providers do not always reflect climate change's severe threat.
Trust says: "Many climate-scenario models in financial services are significantly underestimating climate risk, not through complacency, but because there is a disconnect between climate science and the economic models that underpin financial services climate-scenario modelling. Model parsimony has cost us real-world efficacy."
He adds: "Financial services firms have been focused on production of climate change modelling results, frequently placing heavy reliance on outsourced model providers, meaning there simply hasn't been time to develop a deep understanding of the assumptions underpinning the models and so their limitations."
And why is all this dangerous?
Because as well as firms using these models, financial regulators and central banks are assessing the whole economy and financial system impacts using these models, says Trust.
On the way forward, Trust says: "We recommend education on model limitations and assumptions, alongside development of realistic qualitative and quantitative scenarios."
He comments: "Financial institutions should be encouraged to develop plausible qualitative and quantitative scenarios alongside regulatory ones. A simple quantitative approach could be to use a reverse stress-testing approach based on a ruin scenario of 100% loss of GDP at a certain temperature limit.
"This should be supported by robust internal debate around assumptions, development of appropriate investment beliefs around climate-related risks, and opportunities to foster ownership of assumptions and mitigate risk of group think. This should include developing thinking on ways in which climate change may realistically evolve based on current emissions and warmings."
InsuranceERM's expert judges described the IFoA report as insightful, well-written and with important content that has practical and tangible implications.
