Climate risk uncertainties: “better to be approximately right than precisely wrong”

All - Sep 06 2018

A lot is said and written about climate risks, and today we would like to highlight the uncertainties that climate change issues imply.

As a former U.S. Secretary of the Treasury liked to say: “the only certainty is that there is no certainty”. And even Socrates said: “the only thing I know is that I know nothing.” Such statements could be excessive if they resulted in theoretical and practical relativism, but they also remind us of the humility and determination that we may need when we face unavoidable uncertainties regarding the future in complex environments. The same former U.S. Secretary of the Treasury also added: “despite uncertainty we must decide and we must act”, and Socrates’ paradox clearly did not correspond to the relativistic perspective of the sophists of his time. Relativism can be an excuse for not acting, but the paradox of our limits is rather a strong stimulant for us to search and act. Limited “knowledge” opens to “wisdom”, not to despair or indifference.

It may be useful to remember this when we think of climate change, given both our tendency to focus on “the facts”, and the challenges raised by the uncertainties we inevitably face. We are not talking here about climate scepticism: as the 50% global increase in floods and extreme rainfall events in the last decade or the growing frequency of billion-dollar disaster events in the U.S. attest, we can see a climate problem today and we have a responsibility to act.

However, uncertainties and a lack of appropriate data can make climate action challenging for investors. While carbon emissions tend to be well-documented, other future climate physical risks are difficult to address. Just to mention a few challenges:


  • physical risks are long-term, pointing to both a “tragedy” of time horizons and uncertainties regarding precisely how and when disasters and extreme events will intensify;
  • climate models provide consistent global results but have a more limited capacity to provide forecasts at the local level (for which data are needed when assessing risks at a country, corporate or asset level);
  • natural disasters occur already, and it is difficult to make a direct link between individual disasters and climate change in general (as what is at stake is more a matter of increasing frequency or intensity);
  • the typology of risks itself is not certain, e. should we be more worried about sea-level rise or extreme heat?
  • what magnitude of extreme events should be expected? This will depend on many factors including the level of carbon emissions over time, but also on the level and range of the equilibrium climate sensitivity (“the known unknown”) or on potential risks of non-linear threshold effects with massive impacts (g. what if we the Gulf Stream collapses, the carbon-rich permafrost thaws, or Greenland’s and Antarctica’s ice sheets melt…).

What can investors do today to assess climate physical risks in this context? A certainty is that we see notable climate risks today, and a risk must not be assessed and managed because it is easy to do so, but because of its potential impacts. For example, a recent study by Stanford/Cambridge (MA) researchers states: “relative to a world that did not warm beyond 2000-2010 levels, we project 15%-25% reductions in per capita output by 2100 for the 2.5-3 °C of global warming implied by current national commitments, and reductions of more than 30% for 4 °C warming.” In addition, these current cost estimates tend to be higher than some previous estimates.

It should also be noted that climate physical risks are not the only risks that are associated with uncertainties. This is also the case when dealing with geopolitics or political instability. In these cases, simply weighing probabilities may not be appropriate – for example, averaging probabilities in response to the question “will there be Brexit or not” may provide unsatisfactory results. This could be, by the way, a response to the positions expressed by the former U.S. Secretary of the Treasury whom we quoted. The priority is indeed to ask the right questions (whether they are difficult or not), and the question of climate physical risks is clearly a relevant long-term question for our investments, economies and societies.

So, for investors, first steps could simply be to consider the following elements beyond uncertainties:


  • analytical frameworks, sensitivity matrices (by sector, etc.), methodologies and databases are developing and can be used to support physical climate risk analysis by investors and reduce uncertainties: one of the most recent illustrations of that is the report on “Advancing TCFD guidance on physical climate risk and opportunities” that was recently published by EBRD/GCECA;
  • when dealing with non-sovereign assets, physical climate risks can be a good way to integrate country risk into risk analysis, given the geographic/country dimension of the risks at stake;
  • though physical climate risks may be of low frequency and high magnitude, taking them into account can discriminate amongst assets that otherwise present relatively equivalent characteristics and perspectives on other criteria, so as to minimise risk for a given targeted performance;
  • it is possible to compare several assessments of physical climate risk based on several sources and different approaches, as several methodologies exist and the scopes of physical climate risks considered are different (g. purely physical damages vs. economic damages, integration of adaptive capacity factors vs. focus on risks, etc.). This approach helps to identify consensus: for example, if a country is at risk based on all methodologies, this is relevant information for an investor.

Furthermore, it should also be noted that growing awareness of physical climate risks is also of course a strong reason to collectively invest in energy transition, precisely to limit these risks.

To conclude, uncertainty is an issue when tackling climate risk in investment. However, uncertainty is already associated with other types of risks that matter even for less risky assets (such as sovereign bonds), because of their potential high magnitude and non-linear effects at a broad scale. So physical climate risks do matter and rather than inspiring indifference or relativism, uncertainty could actually encourage our thinking and action. Despite uncertainty, we must indeed act and invest our financial resources, and we should of course do so in the “real economy” where they can be used in a resilient way and serve “real” and needed activities.

Fortunately, physical climate risk assessments are developing, and several analytical frameworks already exist. They will not be precise on everything, but should that be their goal? As Warren Buffet recommends: “It is better to be approximately right than precisely wrong.”

Guillaume Emin, Project Manager –  Source: Beyond Ratings

 

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