Groundbreaking research warns that the models used by the finance sector to predict climate scenarios could easily sink our retirement pots… and the global economy. Huw Morris reports
Economists would call it a perfect storm and the worst since the Great Depression of 1929.
Predatory lending to low-income home buyers, suicidal risk-taking by some financial institutions and the collapse of the US housing market combined to send the global economy into free-fall.
Ultimately, the International Monetary Fund estimated that US and European banks lost around $1trn in toxic assets. Some of those institutions had to be bailed out. This strangled credit, causing businesses to falter, some to crash and unemployment to soar. Evictions went through the roof.
At one point, the UK’s then chancellor Alistair Darling thought the country was within hours of “a breakdown of law and order”. Later on, Iceland’s three major banks went bust. So did Greece.
This was the global financial crisis that started in 2007, was still reverberating into 2011, and wiped more than $2trn from the global economy. Steve Keen thinks it could happen again.
The distinguished honorary economics professor and research fellow at University College London warns that financial institutions, regulators, central banks and governments are ignoring another impending collapse. Climate change could be the culprit this time.
His study for financial think tank Carbon Tracker points to an overnight crisis that has been years in the making. Economists are modelling future markets on “flawed data” that fails to consider climate tipping points, with investment decisions ignoring the economic and physical impact of climate change. Pension funds in particular are risking the retirement pots of millions of people.
Temperature rises and GDP
Keen’s research reveals how many pension funds use investment models that predict that global warming of 2°C to 4.3°C will have a minimal impact on gross domestic product (GDP) and portfolios. Some institutional modelling even claims a 7°C rise in average temperatures would see continuing economic growth. In his review of 738 climate economics papers in leading academic journals, the median prediction was that a 3°C temperature rise would reduce global GDP by 5%. A 5°C rise would see a 10% fall in GDP.
Yet more intense heatwaves, floods
and storms will throttle crops, create uninsurable areas and damage infrastructure, Keen’s study says, pointing to warnings in scientific literature that exceeding the 1.5°C target set by the Paris Agreement would be “dangerous”. Breaching 3°C would be “catastrophic”. Hitting 5°C would pose “existential threats”.
Tipping points, such as the loss of winter ice in the Barents Sea off Norway and Russia or the disintegration of deep convection in the Labrador Sea, could mean more extreme weather. Economists have yet to take these into account, he warns.
“Global warming is not a minor cost-benefit problem that will mainly affect future generations, as the economic literature asserts, but a potentially existential threat to the economy that could occur within the lifespan of pensioners alive today,” Keen says. “We are talking about the financial futures of millions of people.”
His work is one of three major studies this summer to warn that the global financial sector is asleep at the wheel. The University of Exeter is responsible for the other two, one of them with the Institute and Faculty of Actuaries (IFoA).
The first Exeter study warns that plans to transition pension funds to a net-zero future are “dramatically underestimating” the range of risks posed by the climate crisis and failing to account for various “decision-useful” climate scenarios.
Net-zero transition models currently used by pension funds assume that climate-related trends will continue gradually, but – in line with Keen’s study – fail to account for various tipping points that could trigger severe climate and ecological breakdown.
The second Exeter study with the IFoA warns that economic models underpinning climate scenarios in financial services fail to reflect the scale of the environmental threat. This blames a “disconnect” between climate scientists, economists, those building economic models and the financial service professionals using them.
Some current scenarios do not adequately communicate the level of risk if the world fails to decarbonise quickly enough, it argues. They also exclude “second-order impacts”, such as civil unrest and involuntary mass migration, which could significantly disrupt the global economy.
Major factors are also missing from models, this research says, pointing to the assessment of GDP loss in a “hothouse” world of 3°C higher temperatures used by Network for Greening the Financial System (NGFS), a group of 114 central banks and financial supervisors. This does not include “impacts related to extreme weather, sea level rise or wider societal impacts from migration or conflict”.
Firms naturally begin with regulatory scenarios, the study acknowledges, but this may lead to herd mentality and “hiding behind” NGFS thinking, rather than developing a full understanding of climate change. “Benign” models have led financial institutions to believe they would suffer minimal economic impact if the world warmed by significantly more than 1.5°C.
Put bluntly, financial institutions are climate illiterate. For University of Exeter’s climate change and earth system science professor Tim Lenton, who co-authored the study, this beggars belief.
“Some economists have predicted relatively low economic damage – even from extreme levels of climate change,” he says. “It is concerning to see these same economic models being used to underpin climate-change scenario analysis in financial services.
It is essential that financial services institutions and regulators move towards realistic climate scenarios that recognise the potentially catastrophic risks posed by climate change.
“We have left it too late to tackle climate change incrementally. It now requires transformational change and a dramatic acceleration of progress.”
So, what’s the answer? The University of Exeter and the IFoA point to three ways of moving forward:
- Education on the assumptions underpinning the models and their limitations. This aims to tackle silo thinking and the disconnect between climate scientists, financial services and the models the industry uses. Economic models do not reflect climate science. All those involved in climate-scenario modelling – including model providers, professional advisers, governance positions and regulators – need to develop a proper understanding of the science and break down silos.
- Realistic qualitative and quantitative climate scenarios. Financial institutions should be encouraged to develop plausible qualitative and quantitative scenarios. One quantitative approach is using reverse stress-testing based on a “ruin scenario” of 100% loss of GDP at a certain temperature limit. This should be supported by robust internal debate within financial institutions around their assumptions and climate-related risks to tackle group think.
- Models should be reformed to better capture risk drivers, uncertainties and impacts. The University of Exeter and the IFoA warn that “time is too short to wait for models that are perfect”. Financial institutions should look beyond today’s “general equilibrium economic models” and aim to realistically capture risk drivers and the links between policy, technology, the real economy and markets. A practical fix would be using qualitative scenarios, which look at possible futures and reflect the emerging reality of climate change.
For Lenton, a rapid drive towards decarbonisation desperately needs the support of the capital and insurance markets. Actuaries have a crucial contribution to make here, he argues.
Actuaries set assumptions in a model using past data. They look at mortality rates to set assumptions for life insurance or pensions. If mortality improves, they adjust those assumptions accordingly. They also estimate future economic volatility from stock market returns.
A true reflection of risk
Besides actuaries’ role in insurance markets, Lenton says, “their work in pensions means they can impact capital allocation in long-term savings in a way few other professions can”.
Sandy Trust, past chair of the IFoA’s sustainability board and the study’s lead author, points to the urgent demand to develop “realistic downside scenarios that reflect the level of risk we face, as this will inform the level of effort we put into decarbonising”. He adds: “In the context of climate change, it is as if we are modelling the scenario of the Titanic hitting an iceberg but excluding from the impacts the possibility that the ship could sink.
“It is crucial that model users understand the limitations and assumptions of models, take action to break down silos and develop techniques to understand how different combinations of risks will impact future solvency and what actions can help to mitigate this.”
Pension schemes and the environment
UK-based pension schemes have more than £88bn invested in fossil fuels, the equivalent of £3,000 per policyholder, according to campaigners.
An analysis by Make My Money Matter of more than 50 of the nation’s largest schemes reveals that while many have net-zero targets, more than half have Shell and BP in their top holdings. The campaign is calling on pension funds to tell fossil fuel firms to end plans for expansion and set out credible targets for reducing emissions.
However, the problem goes further than polluting industries. Make My Money Matter also looked at the policies and pledges of 77 pension funds and providers that take part in the UN-backed Race to Zero campaign and the Glasgow Financial Alliance for Net Zero. This reveals that just 19% have comprehensive plans to tackle deforestation, both at a top-line level and for specific commodities such as soy, palm oil, leather, beef and timber.
Huw Morris is a freelance journalist