In a new report, the NGO judges that by underestimating the financial repercussions of climate change, economists are encouraging politicians to inaction. Climate risk is growing to disruptive levels throughout the financial system and the guardians of financial stability urgently need to adapt their tools to regain control. Finance Watch’s new report published on its website calls for economic models that do not mislead, scenario analyses that prepare the market, and a new prudential tool to address the build-up of systemic climate risk.
Report – Finance in a hot house world
An uninhabitable hot house
With the world’s current climate action, our planet is on the road of a +3°C average temperature increase: It is becoming a “hot house world” where more than 3 billion people will have to “adapt” to progressively uninhabitable living conditions. Yet policymakers’ economic models predict only a benign level of economic losses from such climate impacts.
Deceiving economic modelling
The cause of such an obvious quantification problem is that the theories behind these economic models rely on backwards-looking data, make assumptions about economic ‘equilibrium’ and use damage functions that are not suitable for modelling an economy disrupted by climate change. Most importantly, the impact of climate change resulting from economic modelling is not compatible with climate science. Yet, the climate scenario analyses conducted by financial supervisors all use these models.
Incentivising supervisory inaction
As a result, the guardians of financial stability are working with highly unrealistic predictions, where the cost of climate inaction is dwarfed and consequently, the small cost of action is seen as too high in comparison. If the cost of inaction were assessed properly, the cost of action would not be an issue for decision makers. Under-estimating the future economic impacts of climate change will reduce our resilience, increase future costs and feed disasters. We need a better choice of economic models and more realistic assumptions.
Improving scenario analyses
The climate scenario analyses conducted by financial supervisors can be easily improved by assessing future economic damages realistically, estimating financial losses from stranded fossil fuel assets and using appropriate time horizons. This should apply primarily to the crucial one-off exercise that EU supervisors are currently undertaking under a European Commission mandate.
A new macroprudential tool for climate risk
Even if economic loss estimates are revised and become realistic, i.e. compatible with climate science, financial supervisors need to adapt existing macroprudential tools to address climate risk: Finance Watch proposes a new ‘loan-to-value’ (LTV) tool for banks’ exposures to fossil fuels that would trigger a capital surcharge once a certain threshold of climate-related risk has been reached, the climate LTV.
The report is available here.
External link
Energy in Demand - Sustainable Energy - Rod Janssen 