Current climate-change scenarios, while effective for policy development, are of little use to investors, and could even be increasing jeopardy. TMI talks to a climate risk scientist from the EDHEC Risk Climate Institute about the issue, and a possible solution.
The precision with which financial projections based on climate-change scenarios have been presented is dangerous, conveying a degree of knowledge that is impossible to achieve, and putting at risk major investment decisions. This is the view of Professor Riccardo Rebonato, Scientific Director, EDHEC-Risk Climate, part of the EDHEC Risk Institute.
Rebonato believes that as we move into uncharted territory with climate change outcomes, the absence of expert knowledge or market experience renders current scenarios “of little use to investors because there are no probabilities attached”.
Having found that some estimates of portfolio losses due to climate change are highly unlikely, Rebonato and his team of scientists at EDHEC set about finding a way of creating scenarios that are better equipped to reflect the full uncertainty of climate-change outcomes, and to enable more effective investor assessment of the relative likelihood of their occurrence. Ultimately, their goal is to offer investors more comfort in their decisions around climate-changed based investments.
Incorrect application
The problem is not necessarily with the models currently used to guide investors – the Dynamic Integrated Climate Change or DICE model, for example is a Nobel Prize-winning solution “for integrating climate change into long-run macroeconomic analysis”. Instead, says Rebonato, it is the “inappropriate use” of a framework that is intended for policy making, in the scenario-analysis setting.
Today, it’s relatively easy for a professional investor to assess the likelihood of outcome when offered a scenario that says a market will, for example, go up or down by 200 basis points (bps) due to an economic event (such as the 2008 global financial crisis); they will have experience of such events and can correlate that with real-world responses and outcomes.
However, experience of large market swings due to climate-based events is minimal or non-existent for all, notes Rebonato. This will change as the impact of climate change grips the world’s markets ever tighter. But for now, climate-based scenarios delivered without any probabilities attached make it difficult for investors to know what to do with this information, or worse, lulls them into a false sense of security or anxiety.
Typically, scenarios offered will present a set of Intergovernmental Panel on Climate Change (ICCP)-derived Shared Socioeconomic Pathways (‘narratives’) alongside a series of Representative Concentration Pathways (RCPs). These pathways are intended to indicate how concentrations of greenhouse gases in the atmosphere will change in future as a result of human activities. Modelling is used to match each narrative with an RCP, giving a set of outcomes.
A related approach is the Shared Socio-economic Pathways (SSPs), which are scenarios used to predict how climate change will alter in response to global socio-economic indicators, such as population, economy, land use, and energy change.
“The problem is that there are no probabilities attached to these combinations, so the investor has no idea if they all have the same probability or whether one should be treated more seriously than another,” warns Rebonato. This is why his team has “looked under the bonnet” of these offerings and is trying to imbue them with more realism, and thus efficacy, as investor guides.
Other outcomes are possible
Some of the consequences of combinations offered were found by Rebonato to be “implausible”. In one, the social cost of carbon (i.e. as taxation) would be around of 10% of GDP. An investor cannot know (although they may suspect) that when using this scenario, this outcome is virtually impossible. “Globally we currently spend 3% each on education and the military, and 7% on healthcare, so spending 10% of GDP on addressing climate change is not very likely.”
This demonstrates how the lack of attached probability might steer investors in a wrong direction. Of course, the process of assessment should be refined over time as more data becomes available, but currently SSP and RCP scenarios are deemed the ‘gold standard’.
The Network for Greening the Financial System (NGFS) – a group of 114 central banks and financial supervisors collaborating to accelerate the adoption of green finance – has attempted to create a more investor-friendly scenario. It has used just one narrative, and applied to it a series of global temperature outcomes.
“The one story they have singled out is referred to as ‘middle of the road’,” notes Rebonato. “This is fine if you’re only interested in a limited viewpoint of what is likely. But it is not OK if you want to understand what happens if the world fails to control emissions as much as it should, or if the consequences of climate change are much worse or better than predicted.”
With no element of probability distribution in this approach, the risk is that investors will base their portfolios on a narrow outlook that is attempting to cover a very long-term forward-looking development, but one that cannot be supported by market experience. This is why Rebonato deems the current approach by the investment world to be fraught with risk.
Misplaced trust
In the investment world, it’s likely that pension fund trustees, for example, will have called upon consultants to advise on the possible effects of climate change on their portfolios. It’s a wise course of action in principle. But having seen the results of some ‘investigations’, Rebonato’s enthusiasm is dulled somewhat. Using the horizon of the 2030 climate challenge, predictions have been offered to a precision of within one hundredth of a percentage point.
Claiming that a certain asset class will perform to within this degree of accuracy is, he states, “not only ridiculous but also dangerous”. An investor exposed to these results may be lured into believing the consultant has access to a super-precise scientific methodology. But, warns Rebonato, they do not. Indeed, no one has.
One of the less-than-sensible scenarios he cites concerns the financial impact of a 4°C increase in global temperatures by the end of the century. This is in completely uncharted territory, and yet such an outcome resulted in a mere 0.5 to 1% negative impact on portfolios.
The type of models used for these outcomes have seen many improvements since the early days. The understanding around climate change has also increased considerably since then, such that it is no longer possible to publish a new academic paper using older versions of the famous DICE model.
However, what Rebonato believes has happened is that old-style ‘damage functions’ have been used in the stress-testing exercise. Damage functions are used to translate an increase in temperature into economic harm. The process of optimisation requires the avoidance of significant damage, which means keeping the temperature shift to a maximum of 2.5 to 3°C, so optimisation models (such as DICE) use damage functions that are not designed to go beyond this ceiling. Using the same function for scenario analysis above and beyond that point, and simply extrapolating the results into a smooth upwards curve, therefore fails to consider the likelihood of exponential increases in harm as temperatures rise.
While Rebonato admits to not having proof that this is what has occurred, he says that if he “inappropriately” uses the old-style damage function for scenario analysis in this way, the results tend to agree with his suspicions.
The ultimate effect of placing faith in the output of older versions of an inappropriately used framework is that some investors may feel a little too comfortable with the outcomes, says Rebonato. They may then be led towards investments that are not right for them. Conversely, some may be guided to the polar opposite ‘catastrophic’ view of climate change. They will still have no grasp of certainty (or rather uncertainty) around outcomes, but instead play overly cautious.
The key observation here for Rebonato is that while policy-makers will usually err on the side of caution, investors are facing “no right way to be wrong: if an investor is too conservative, their portfolio will suffer just as much as if they are too aggressive”.
Know your climate
Investors need to know what is a reasonable central estimate, and what is the spread of possible outcomes. The two potential issues here that must be reiterated are a lack of communication of the degree of uncertainty, and the ‘low-balling’ effect on risk stemming from the inappropriate use of an outdated model.
The solution for investors starts with robust due diligence on the sources of information, advises Rebonato. “Asset managers should already be engaged with this topic; it’s their job. But other investors, such as pension fund trustees or corporate treasurers, will probably need advice. They should make sure that their consultants not only have experience in straightforward financial matters but can also match that expertise in climate-change related issues, otherwise the risk is that their adviser is simply improvising on their guidance.”
The purpose of Rebonato’s work at the EDHEC Risk Institute is to try to create “an investor-friendly balanced picture” that takes into the account the latest scientific, financial and economic knowledge, and determines where gaps in that understanding exist.
While the finished solution is not quite ready – delivery timescale is being measured in months not years – an approach has been formulated and the testing is underway. The method builds extensively upon a modern version of the DICE framework to create linked economic and climate outcomes. The former considers how populations grow in line with GDP per person. It also incorporates carbon-intensity data (this explains the level of carbon needed to create a single unit of energy in each economic region: richer countries use less, developing countries need more), and energy-intensity data (or how much energy is needed to generate a single unit of GDP).
“We’re seeking all the empirical evidence and regularities that we can find, and while we’re relying on models, it’s only to give us structure,” comments Rebonato. The simulations created so far, he explains, give a distribution of temperature outcomes that are translated into economic damage. To do this, the team takes a number of data sources, and intends to apply its own “high resolution” research and understanding, enabling it to explore, aspects such as changes in productivity as a function of temperature increase for specific areas of the globe.
With outcomes from the EDHEC approach generating new forms of information, investor consumption must be made as easy as possible to encourage uptake. Having been on investment committees and boards over the years, he knows that the dashboard presentation of data often received at this level can provide a highly distilled yet useful expression of performance of various corporate financial activities.
However, while experience is still required to read these familiar fiscal and financial metrics, the complex nature of climate-change data requires a deeper level of engagement than is typically available in this context. Rebonato is prepared for investors to say that they cannot readily digest the distribution of outcomes from the EDHEC model. The team is therefore creating a range of prepared scenarios for ease, but, importantly, all with probabilities attached. This should enable investors to understand the likelihood of certain climate-based outcomes happening, and to apply that knowledge to their portfolio management.
Uncertainty principles
For corporate treasurers either actively engaging in climate-related investments, or considering them as part of their portfolio, Rebonato cautions them to view any associated data as having a “huge uncertainty-bar” associated with it. “Make your decisions as if the climate-related information you’re offered has 10 times as much uncertainty around it as the economic and financial information you use. If it means you are a lot more uncertain about the outcomes of these investments, then don’t do it.”
As a physicist, Rebonato has a stronger grasp of climate science than those in other disciplines: our climate system is governed by physical laws. Yet he admits that what this strand of science understands about climate change is known with much greater uncertainty than people assume. He believes that references to the 2015 Paris Agreement signatories’ commitment to limit the global average temperature rise to between 1.5 and 2°C “gives the impression that we can land our economies to a 0.1°C-precision, but the level of uncertainty in physics alone is larger than 0.5°C”.
There’s a clear mismatch here: “Even if an investor is told exactly what the emission pathway between now and the end of the century will be, scientists still cannot say what the resulting temperature will be within that level of precision. Investors should keep this in mind. We are moving in uncertain territory, and while the shape of the distribution curve has very little room for surprise on the positive side, there is a huge amount of room to be surprised on the negative side.”
In terms of the impact of climate change on investment portfolios, understanding the probabilities suddenly seems like a good idea, and without them, caution is recommended.
