05 July 2023

Institute/Faculty of Actuaries: The Emperor’s New Climate Scenarios

Using actuarial principles to examine current climate-change scenario analysis limitations and assumptions yields a number of worrying observations, including - Many current climate-change scenario models are understating risk, showing benign, or even positive, economic impacts...

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:

• Many current climate-change scenario models are understating risk, showing benign, or even positive, economic impacts from a hot-house world in which we fail to limit global warming
• There is considerable uncertainty around how much and how quickly we expect the climate to warm – we may have seriously underestimated the pace of climate change
• This translates to uncertainty in carbon budgets, with a real chance that the carbon budgets for 1.5°C of warming are now negative
• This points to the importance of users of scenario analysis in financial services understanding these limitations and assumptions, and the responsibility to create more realistic models and craft detailed qualitative scenarios
• This underlines the need to race to net zero – with an intentional focus on accelerating a range of positive tipping points in socio-economic systems that we can control.

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:

• Scientists use evidence to prove theories, so would not typically say there is an iceberg until they are fully confident there is one present
• Risk managers use their imagination to think about what could go wrong. There could be an iceberg so we should typically steer well clear of it.

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....

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