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Finance Watch warns: Economic models underestimate climate risks

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The economic models used to calculate the risks of climate change to economic growth and financial stability are “disconnected” from climate science and perpetuate an inaction bias in policymakers, a new report by the financial policy NGO Finance Watch warned.

According to Thierry Philipponnat, chief economist of Finance Watch, many analyses of the economic impact of climate change fail to take into account tipping points and feedback mechanisms that make the effect of climate change hard to predict.

“The economic risks of climate change are currently modelled in a similar way to traditional financial risks. But unlike past financial losses, the losses from climate change will be disruptively large, unpredictable, and permanent,” the report said.

The problem, according to Finance Watch, is that regulatory agencies and governments still largely rely on such outdated models.

As an example, the NGO pointed to a 2020 report by the Financial Stability Board on the “Implications of Climate Change for Financial Stability”.

When determining what the impact of global warming of around 4 degrees Celsius would mean for the value of global financial assets by the year 2105, the report referred to a 2015 study by the Economist Intelligence Unit that suggested a negative impact on asset values of 3-10%.

These figures seem very low given what climate science says about a world that heats up by 4 degrees Celsius.

According to the sixth assessment report of the UN Intergovernmental Panel on Climate Change (IPCC), a warming of that scale would lead to a loss of between 80% and 100% of species in some tropical regions, especially in the sea.

Moreover, those regions would suffer from more than 300 days per year in which heat and humidity are at levels that pose a risk to human health.

Crop and fishery yields would be likely to collapse in tropical regions. Extreme weather events would be more frequent and more violent, and sea levels would rise by about 80cm until 2100, though this could be higher as well.

It is hard to believe that such profound changes, their second-round impacts, as well as the refugee movements and the geopolitical conflicts they are likely to entail would only lead to a negative impact on asset values of 3-10%.

Philipponnat therefore called on economists to “adapt economic models or they’ll undermine both climate change mitigation and adaptation”.

“Economists analysing the impact of climate change must not be complicit, even if unwillingly, in the inaction of policymakers,” he said.

“They have a responsibility to open their eyes to the economic and financial impacts of a hothouse world.”

With its report, Finance Watch also targeted the European Commission and the European financial supervisory bodies.

The Commission has tasked the European Supervisory Authorities, the European Central Bank, and the European Systemic Risk Board to perform an assessment of climate change-related risks to the financial system as a whole over the period up to 2030.

The report should be ready by the end of 2024 or, at the latest, early 2025.

However, for Finance Watch, the short time horizon of 2030 risks making the exercise futile.

“The world is unlikely to reverse its current expansion of fossil fuel consumption before that date,” the NGO stated, arguing that this would mean that financial stability risks from stranded fossil fuel assets are unlikely to be detected under such a short-term scenario.

Secondly, Finance Watch also proposed a new “loan-to-value tool” that should be applied to the fossil fuel exposures of European banks. This tool would force banks to back up their exposures to fossil fuels with additional capital as soon as a certain threshold of climate-related risk has been reached.

[Edited by Zoran Radosavljevic]

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