The Financial Sector Is Failing to Estimate Climate Risk, Say Two Groups in the UK
The financial sector is failing to grasp the risks of climate change to their customers and to the global economy, which has undercut the urgency to take action to reduce those risks by cutting emissions.
This is according to the Institute and Faculty of Actuaries in the United Kingdom, which issued a report this month, “The Emperor’s New Climate Scenarios.” The authors argue that many financial institutions, including pension funds, are relying on economic models that underestimate the cost of climate change.
Also this month, the environmental nonprofit ClientEarth said the world’s six largest accounting firms are failing to deliver on commitments to improve how they address climate change in financial reporting.
The actions from the actuaries and ClientEarth are part of a growing push from advocacy groups and regulatory agencies to increase disclosure of climate risks and improve the quality of forecasting of potential damages.
The underlying idea is that corporations and pension funds are not adequately accounting for how climate change may harm their performance, which means customers and shareholders don’t know how much they are at risk, including the risk that their retirement funds could lose substantial value.
“There’s a massive gap where the messages of Earth science and climate science have not affected finance to any significant degree, and that is a problem,” said Mike Clark, who is affiliated with the actuaries’ group but is not one of the report’s co-authors. He also is the founder of Ario Advisory, a financial consulting firm, and a visiting fellow at the University of Exeter.
Clark cites West Midlands Pension Fund in the U.K. as an example of an organization using models that underestimate climate risk. The fund issued a report in December that looked at various warming scenarios and how they would affect the fund’s performance. The report said that an increase in the global average temperature of 4 degrees Celsius compared to pre-industrial levels—a level that many climate scientists have said would be catastrophic—would reduce the fund’s value by an annual average of 1 percent by 2040.
“When we see some of these numbers, describing them as ‘optimistic’ seems rather generous,” Clark said.
Inside Climate News asked West Midlands Pension Fund to respond. The fund said in an email that it welcomes the report from the actuaries and “will continue to evolve and publish its risk analysis and reporting as new research emerges.”
ClientEarth has been engaging with accounting firms for years to improve the ways that the companies calculate and report the climate risk of their clients. The nonprofit sent a letter in May that goes into detail about the concerns. This week, ClientEarth expressed disappointment that the firms do not seem to be serious about taking action.
“Investors are repeatedly demanding better reporting,” Robert Clarke, a lawyer at ClientEarth’s London office, said in a statement. “Standard setters have already said this is required under existing rules. It’s time the auditors step up and drive the necessary change.”
ClientEarth has been communicating with the Global Public Policy Committee, a group made up of leaders of the six major accounting firms: BDO, Deloitte, EY, Grant Thornton, KPMG and PwC.
The committee has not made a substantive reply in recent months, according to ClientEarth.
However, the committee did publish a statement this month that responds to the criticism.
“GPPC networks are committed to reporting consistent, high-quality information to support stakeholders’ decision making,” the committee said. “We perform our work in full compliance with existing standards. However, we recognize some want broader information than current standards require.”
The committee went on to say, “We strongly support standard setters’ efforts to address the current information gap, for example, greater connectivity between sustainability-related corporate disclosures and financial statements.”
While the actuaries’ and ClientEarth’s efforts are separate, they explore a similar issue, which is that the business world is largely unprepared for the scale of damage that will accompany severe warming, including the harm that would come with climate change tipping points. Tipping points are often irreversible changes and they are difficult to predict.
“Once tipped into a new state, many of these systems will cause further warming—and may interact to form cascades that could threaten the existence of human civilizations,” said Tim Lenton, chair of climate change and Earth system science at the University of Exeter and a co-author of the actuaries’ report. The actuaries produced the report in partnership with the university.
Gernot Wagner, an economist at Columbia Business School who was not involved with the report or ClientEarth’s actions, said he agrees with the idea that financial institutions are underestimating the costs of climate change, but he is frustrated with the way that critics tend to be overbroad in blaming the field of economics.
Some economists, including him, have been talking about the dangers of underestimating climate risk for decades, he said.
He thinks one of the big problems is that projecting the financial effects of climate change is extremely challenging. The results have tended to err on the side of showing small effects.
“It is just really difficult to quantify, and lack of quantification is akin to underestimation,” he said.
The actuaries’ report recommends a combination of approaches to help the financial sector grasp its climate risk. One is to do what the authors call a “reverse stress test,” which is to identify a scenario that the public would like to avoid, and then work backwards to determine what would be needed to avoid that outcome.
Another approach is to use narrative scenarios as opposed to just numbers. This would mean describing what the future may look like and the factors at play, which would allow a discussion of risks that can’t be quantified.
Wagner said he is seeing progress in recognizing the economic risks of climate change, which is contributing to a greater effort to reduce the risks, although the progress is far from what’s needed.
He acknowledges the discussion about risks and tipping points can be discouraging, but also notes that there are positive tipping points in the form of clean energy technologies and new government policies.
“This green industrial revolution is well underway,” he said. “Millions of jobs are being created on the clean energy side as we speak.”