Wendy Walford explores the emergence and interaction of climate risks over different time periods, and discusses the implications for actuarial work
Climate change presents a material financial risk, and it will impact the work that actuaries carry out. One of the key challenges in incorporating climate considerations is the time horizon over which they emerge.
While the physical impacts of climate change are expected to emerge outside of the time horizons for business planning, the actions that are needed to avoid these long-term risks need to be taken now; this has been referred to as the ‘tragedy of the horizon’. Unless the world takes decisive action immediately, physical risks will start to emerge gradually during this century. While this is too late to impact our assessment of physical risks next year, the choices we make in that year will influence those long-term risks.
Consider the market price of a property, which represents the discounted future expected value that will be derived from the asset. The more frequent and severe weather events associated with climate change will lead to an increase in the future costs involved in repairing additional damage or even abandoning the asset; this affects today’s value. Today’s impact will depend not only on the size and timing of these future costs, but also on the likelihood that these events will happen. If consensus were to build that the world is on a severe warming pathway, then the adverse impact on the asset value may be recognised sooner and potentially suddenly, as investors reflect the increased likelihood of climate-related future costs.
The likelihood of physical risks can be reduced by taking strong co-ordinated action to move away from a high-carbon economy. However, this leads to transition risk. Given the urgency around addressing climate change, we can expect transition risks to emerge sooner than physical risks, but the time horizon for when they may emerge is also very uncertain.
Transition-related market impacts do not always emerge through the actual implementation of regulations – they may arise from changes in consumer sentiment, or just from an increased expectation that these regulations will be put in place, which can shorten the time horizon.
For the global economy to transition, concerted joined-up action is needed. However, current global progress on Paris Agreement commitments falls significantly short of the emissions reductions required by that agreement. This increases the likelihood of systemic costs arising from a failure to mitigate climate change. There is a further risk that this outcome is reflected suddenly by markets, increasing disruption.
Investments and risk exposure
Investment choices made today impact exposure to climate-related risks and also influence their likelihood. Investing in ‘green’ assets might be predicted to produce lower returns based on non-climate aware valuation techniques, but these investments are likely to outperform in a strong mitigation environment with high carbon prices and other measures. These assets also directly reduce the risk of a failed transition to a low-carbon economy.
Conversely, investments in high-carbon technologies may seem attractive today, but they are likely to underperform in a strong mitigation scenario. Furthermore, these investments prolong support for carbon intensive business models, delaying the transition and increasing the chance that we remain on our current climate pathway – entailing associated future adverse financial impacts and wider societal costs.
Incorporating climate risks
To understand and manage the risk attached to any form of projection, we need to understand the climate assumptions underlying the modelling. The one thing we cannot do is ignore climate impacts and assume that we can continue on our current path without consequence. Actuaries need to recognise the balance between physical and transitional risks in their work. Future projections are always uncertain; we need to understand and communicate the uncertainty, including how climate could affect the outcomes.
Wendy Walford is an actuary working in risk management at L&G and a member of the IFoA Sustainability Board