Clarity on climate

There is considerable uncertainty in the output of climate change risk and exposure data – how should decision-makers cut through all this? Russ Bowdrey explains.

Have you heard? Actuaries can save the world! Well, sort of. If we set aside our love of fine detail and getting super-nerdy over the models, we can draw on a key part of our skillset in acting as ‘master translator’ for decision-makers – helping them to slice through the fuzz of uncertainty and take decisive action. The key is to not fixate on the numbers, but instead to consider the trends that will lead to the right outcomes.

The critical first step is, sensibly, measurement. But how do you make sure you take it seriously? In short: disclosure. The point of committing to disclose is to give the business the insight it needs to understand this ‘new’ risk. Take a look at Travis Elsum’s excellent article from the February issue of The Actuary (bit.ly/TravisETheActuary), showing what leaders in this field are doing. It is worth bearing in mind that taking climate disclosures seriously will not be optional for much longer, and that those viewed as leaders are not that far down the road. This is not to detract from their achievements – they have certainly expended a lot of time and effort – clearing a new path always takes a lot of work. However, with a focused project, appropriately guided by those with domain knowledge, it is very possible to catch up. Committing to disclose and applying a short concerted effort will yield a rich dataset for internal use – even if disclosing it all may be unwise until the market has learnt how to digest such information.

Let’s call these data ‘climate change metrics’. They include, for example:  

• Carbon footprint  
• Emissions intensity  
• Portfolio warming potential  
• Exposure metrics  
• Climate scenario losses.

Model risks

It’s rapidly becoming clear that climate change data will become as crucial to disclosures and risk management as market data. This is why the leading vendors of climate change risk data have been snapped up by big names in market data and ratings in the last year. But here is the rub: despite the Herculean effort of those involved in producing climate change metrics, if you scratch the surface of any climate-related metric you find a lot of the features we dread in model output:  

• Spurious precision  
• Parameter uncertainty  
• Model uncertainty  
• Misleading parameter/output naming  
• Conflict of interest in assumption setting  
• Bias/anchoring triggering units.

How useful is this for making tangible, profit-moving, risk-reducing business decisions? In my experience, using the figures in absolute terms, not very useful at all. There is simply too much going on: what does it even mean to align a portfolio to a temperature? And if you believe you can, is 2.4˚C better than 2.5˚C or is it materially the same? What is Climate-VaR? Is the one you’re looking at even a value-at-risk? This simply breeds confusion and paralysis.

Then there is the uncertainty embedded in the analysis, something that we as a profession should be comfortable dealing with. Until we’re actually faced with it. Just think about the components required to assess the portfolio warming potential alignment of a portfolio – I need to:  

• Work out the trend of emissions that might lead to ‘Paris-aligned’ temperature rises in 2100. Then do the same for other temperature rises. There are multiple paths for each, none of which are certain to result in Paris alignment (or better) – leading to uncertainty #1.  
• Work out what emissions we attach to different activities (hundreds, if not thousands if we’re doing this properly). We can reasonably estimate this in the near term, but such is the pace of technological change that beyond 10 years, this is guesswork – which gives rise to uncertainty #2.  
• Attribute the activities of each company to those described above. Even doing this for today is hard, as few firms disclose revenues in enough granularity. Moreover, no company publishes (or even creates) business plans beyond three to five years, but we really need 80 years – so are left with more guesswork, and uncertainty #3.

For each uncertainty we need a model, with assumptions about how the world works. These are choices that are often driven by expert judgment. This drives a lot of variability between different providers. Even individual providers change their models from time to time, with material differences in output. If you use a consistent model over time (or can accurately say what changes in a model do to its outputs), then you can start to extract meaningful relative measurements.

Don’t let ‘perfect’ stand in the way of ‘good enough’

But – and it is a big ‘but’ – used on a relative basis, this data is good enough to act upon. Especially given that we know we have to take decisive action now. We can take actions that are directionally right, without needing to know every underlying detail with total precision.

What do these insights look like, and why can we be happy with such a broad-brush approach?  

1. There is considerable concentration of climate change risk in a few names/assets.  
2. If we normalise the data, stripping out units that might anchor or distract users trying to interpret unfamiliar data, and carefully controlling for model or parameter drift, then we can infer trends. Yes, it’s simplistic. Yes, it’s not perfect. But these cut through the fuzz of uncertainty and get to the heart of what we need to achieve: the transition of our portfolios towards supporting a green economy and away from (soon-to-be) stranded assets and those imperilled by physical climate change risk.

This approach will lead to decision-useful outcomes, particularly helping us to identify hotspots of risk and a more streamlined list of assets on which to focus our attention. Using these, we can engage with our asset managers and get them to apply their skillsets to validating what we’re seeing in the climate risk data. For example, equity and credit analysts are well placed to consider what could happen to a business’s revenues or physical assets under plausible but extreme climate scenarios. Asset managers can use this to place a higher priority on engaging with management on key climate change topics, such as adapting the business mix. Consequently, the CIO and CRO, informed by both the climate change metrics and insights from the asset managers, can make well-informed decisions about rebalancing long-term portfolios with climate change risk in mind.

A call to action

Here is a call to action with regard to three aspects of assessing climate change risk, and using it to make world-changing impacts via investments and engagement.  

1. Be mindful of biases, anchoring and fixation on meaningless details
   There is, rightly, a strong call from policymakers for investment funds and investors to publish the alignment of their funds to doing the right thing for climate change. However, the inconsistency of these measures makes comparison very hard. When considering your own funds and risk profile, be mindful of fixation on meaningless detail and challenge yourselves on cognitive biases.  
2. Challenge conflict of interest positively
   For financial institutions, the most widely used source of scenarios for projecting emissions pathways is produced by the International Energy Agency (IEA). This intergovernmental body historically safeguarded the supply of fossil fuels, and is partially funded and staffed by that industry. So without agenda, one should be wary of potential conflict of interest here. The criticisms of systematic bias in their projections are well documented elsewhere. However, the IEA dataset should still be accepted as part of the set of plausible scenarios. Importantly, I would like to see the whole financial sector come together to fund an independent, unconflicted scenario set.  
3. Challenge yourself and your firm to reflect on the true nature of this risk, how it affects you, and start to take mitigating action 
   While there is currently no requirement to explicitly reflect climate change under Solvency II Pillar 1, most regulators expect it to be covered in Own Risk and Solvency Assessment and in raising supervisory expectations. In my mind there is a distinct competitive advantage for early movers and incentives to act: customers want it, shareholders are demanding it and are holding boards accountable.

Climate change, and the associated mitigation and adaptation required from our businesses and the wider world, is so far-reaching that there are few areas of business actuaries are involved in that will not be touched. Helpfully, the profession has prepared practical guidelines (bit.ly/2V88wAP).

Now, what are you waiting for?

Russ Bowdrey is a senior ALM manager at Aviva, and led the Climate Change Physical Risk Workstream for Aviva’s TCFD report

Image credit | Ikon