Financial institutions still underestimating climate risks
Source: Middle East Insurance Review | Aug 2023
Financial institutions may still be underestimating climate-related financial risks due to a disconnect between climate scientists, economists, model builders and financial institutions, according to a new report by the Institute and Faculty of Actuaries (IFoA) and the University of Exeter.
The 32-page Emperor’s New Climate Scenarios – a warning for financial services study report reveals that companies often use models that produce ‘implausible’ outputs and have significant blind spots when it comes to estimating potential hazards, exposures and vulnerabilities under different climate scenarios.
This ultimately limits the usefulness of these models in assessing the true extent of financial institutions’ (banks, insurers and investment firms) climate risks. For example, the report says the current modelling techniques exclude many of the most severe impacts expected from climate change, such as the emergence of climate tipping points and secondary effects, like global food supply shocks and mass migration. As a result, they generate overly benign outcomes, which can mislead financial institutions on the full extent of their risks and potentially delay action on decarbonisation.
The report recommends that to improve financial firms’ climate risk assessments, the model users should become climate literate and use these tools alongside narrative scenarios that qualitatively describe the potential risks and their impacts.
Additionally, institutions should incorporate out-of-model adjustments and error margins in their analyses to account for uncertainties that the models fail to capture.
The other major recommendations of the report include:
- Carbon budgets may be smaller than anticipated and risks may develop more quickly
- Regulatory scenarios introduce consistency but also the risk of group think, with scenario analysis outcomes being taken too literally and out of context
- Education is needed on the assumptions underpinning the models and their limitations
- The development of realistic qualitative and quantitative climate scenarios is required
- Model development is required to better capture risk drivers, uncertainties and impacts
The IFoA said the objective in writing this paper is to help accelerate the progress of more realistic scenario modelling, which, it hopes, will help to further accelerate the progress on decarbonisation. M