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A new paper from the Institute and Faculty of Actuaries (IFoA) and the University of Exeter claims that current climate-scenario models used within the financial services sector are ‘significantly underestimating climate risk’.

The paper, ‘The Emperor’s New Climate Scenarios’ seeks to demonstrate how a deeper understanding of climate change, including tipping points, can improve climate-scenario modelling within the financial services sector.

The paper uses actuarial principles to examine the limitations and assumptions in relation to climate-change scenario modelling practices in financial services, focusing on 'hot-house world' scenarios of 3˚C or more of warming. It demonstrates how current techniques exclude many of the most severe impacts we can expect from climate change, such as tipping points and second order impacts – they simply do not exist in the models meaning the models understate the level of risk.

Key findings highlighted in the paper include:

  • Many climate-scenario models in financial services are significantly underestimating climate risk.
  • Carbon budgets may be smaller than anticipated and risks may develop more quickly.
  • Regulatory scenarios introduce consistency but also the risk of group think, with scenario analysis outcomes being taken too literally and out of context.
  • Education is needed on the assumptions underpinning the models and their limitations.
  • The development of realistic qualitative and quantitative climate scenarios is required.
  • Model development is required to better capture risk drivers, uncertainties and impacts.

Read the paper (PDF).

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