Climate scenario models in financial services significantly underestimate climate risk, IFoA warns

Written by Adam Cadle

04/07/2023

Economic models underpinning climate scenario modelling in financial services do not always reflect the threat climate change poses to the planet and society, a new report from the Institute and Faculty of Actuaries (IFoA) has argued.

The Emperor’s New Climate Scenarios – a warning for financial services stated that some current scenarios could have limited use as they do not adequately communicate the level of risk society is to face if it fails to decarbonise quickly enough.

The IFoA said techniques being used now exclude many of the most severe impacts of climate change such as sea level rise, heat stress or climate tipping points, where a change in the climate system becomes self-perpetuating such as the loss of Arctic sea ice or the Greenland ice sheet. Second order impacts for human society such as civil unrest and involuntary mass migration which could cause significant economic impacts are also excluded, the IFoA added.

The report laid out how the results emerging from current models are far too benign and, in some cases, implausible, using actuarial techniques to examine the limitations and assumptions of models used. “This severely limits the usefulness of the models to business leaders and policymakers, who may reasonably believe these models effectively capture risk levels, unaware that many of the most severe climate impacts have not been considered,” it said.

The report also highlighted the uncertainty in carbon budgets, where there is a wide error margin, meaning there is a risk that ‘net-zero’ carbon budgets may already be exhausted.

Professor Tim Lenton, from the University of Exeter, said: “Some economists have predicted relatively low economic damage – even from extreme levels of climate change. 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. We have identified a variety of positive tipping points in human societies that can propel rapid decarbonisation. We need the support of the capital and insurance markets to achieve this, and actuaries have an important contribution to make. In addition to their role in the insurance markets, their work in pensions means they can impact capital allocation in long-term savings in a way few other professions can.”

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