Pension funds are risking the retirement savings of millions of people by relying on flawed climate economics, and could be liable for their failure to effectively address climate risk.
Global warming, at less than 1.5°C, is already affecting people and companies across the planet. Record heatwaves, floods, and intensifying storms halt commerce, damage crops, create uninsurable areas, and impair infrastructure, among other significant impacts.
The potential costs are immense and yet forward modelling suggests that overall economic impacts will be fairly low. That’s because just as mainstream economists failed to predict the global financial crisis in 2008 – the worst economic crisis since the Great Depression – they could now be steering the world toward another crash.
This is according to research from Professor Steve Keen, a Distinguished Research Fellow at University College of London and author of Can We Avoid Another Financial Crisis and financial think tank Carbon Tracker in their latest analysis Loading the DICE against pension funds.
What’s wrong with current climate economic models?
Professor Keen’s argument is that current economic models ignore critical scientific evidence about the financial risks embedded within a warming climate. Instead of taking climate science and calculating their impact with a financial model, they take their own data and run scenarios based on their selection.
Most use a Dynamic Integrated Climate-Economy (DICE) approach which estimates impacts based on subjectively selected costs and benefits of taking action on climate change. Keen points out that none of them to date even include the impact of precipitation – given the impact of floods and drought, that’s a little concerning.
He contrasts scientists’ empirical research with predictions by climate economists that are “a ‘hunch’ based on rather spurious assumptions for global warming, which have been used to generate equally spurious estimates of damages to future GDP.”
A survey of 738 climate economics papers in top academic journals found the median prediction of economists was that 3°C of warming would reduce global GDP by just 5%, and warming of 5°C would see a 10% reduction. Nobel prize-winning economist William Nordhaus has been even more sanguine, predicting that a 3°C rise would reduce global income by only 2% and 6°C by 7.9%, compared to what it would have been in the complete absence of global warming.
The report argues that the “strikingly false assumptions” by climate economists persist because their studies are peer-reviewed only by other economists, rather than by climate scientists. As a result, they ignore the likelihood of triggering climate “tipping points” that will accelerate economic damage. Keen says: “The framework for approaching attenuating climate change was created by a climate change denier. Not denying climate change is happening but that it doesn’t matter – which makes us deluded about the challenges we face.”
The reports quotes different scientific research which argues that exceeding the 1.5°C Paris target would be “dangerous”, passing 3°C would be “catastrophic”, and reaching 5°C will be “beyond catastrophic, raising existential threats”.
While climate scientists and some leading economists, such as Nicholas Stern and Joseph Stiglitz, have challenged the inadequate climate risk models used in economic reports, the majority of economists have not aligned their reports with climate science. This means the information being provided to pension funds and to central banks (who run their own climate stress testing scenarios) is massively underestimating the risk – so it’s no wonder they are showing no urgency to realign their capital investments.
Pension fund officers and trustees may be liable
The challenge for finance offices and pension trustees, as pointed out by Carbon Tracker Initiative founder Mark Campanale, is how such models are being applied in the real world. Finance officers and trustees rely on investment consultants for relevant information. They in turn rely on specialists who rely on these models – and no one is checking on the data or the models.
Unfortunately what that leaves in the models suggests little change in the value of assets over time. If that’s the case, then most asset managers will focus on operating business as usual – which is a real challenge when finance officers performance is often gauged on how their performance is diverging from the benchmark.
Most financial market participants accept figures from the FSB, NGFS, and consulting firms like Mercer as accurate so “it is highly likely that stock market valuations are wildly out of step with the future course of stock prices, dividends and GDP in a climate-changed world,” says the report. Financial regulators must drastically revise the stress tests they use to test the exposure of financial institutions to climate change.
If the impact of GHGs and global warming gets much more obvious, governments may have to enact drastic regulation to cut emissions rapidly. Today cereal production in southern Europe is expected to fall by up to 60% due to the impact of the Charon heatwave. Imagine the impact on asset values, especially in GHG emitting oil and gas, if states decide that emissions must fall 50% in a decade?
Campanale is asking portfolio managers to commission officers to do sensitivity analyses and present the results – to even have a chance of understanding the potential risk. If the advice given to pension schemes is patently wrong, he points out, that doesn’t free up trustees and finance officers from their fiduciary duty. He says: “Go and get updated advice driven by the accurate assessment that even at today’s level of warming it will be a catastrophe.”
Remember the global financial crisis?
Before the 2008 global financial crisis, markets seriously underestimated the sheer scale of financial risk in the system and how this could damage the real economy and household finances. The Financial Stability Board was set up to ensure that this didn’t happen again, and itself set up the Task-force for Climate-related Financial Disclosure in order to gain better insight into the risks from climate change. But if flawed economic and financial models dominate the discourse and the presentation of risk, there will be no greater clarity on the risk in the system.
Mick McAteer, Co-Director of the Financial Inclusion Centre & former Board Member at the UK’s Financial Conduct Authority, said: “This powerful new report exposes how an even graver underestimation is now happening, this time in relation to climate risk. Advisers, consultants, and asset managers continue to underestimate just how exposed the financial system is to climate change. Worryingly, the causes of this underestimation appear to be the same – flawed economic and financial models promoted by experts and conflicts of interest in the financial system.”
As Keen warns: “Global warming is not a minor cost-benefit problem that will mainly affect future generations, as the economic literature asserts, but a potentially existential threat to the economy, on a timescale that could occur within the lifespan of pensioners alive today. We are talking about the financial futures of millions of people.”
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