Investors' scenario testing not recognising full climate risk, warns academic
Environmental Finance 23/01/2024
"The climate scenarios currently used by investors are not fit for purpose and do not adequately assess the full extent of risks, an academic has warned.
The scenarios most investors are using were ultimately created for the purpose of policymakers, but not for the use of investors to assist with decision-making,warned Riccardo Rebonato, scientific director of the Risk Climate Impact Institute at the EDHEC Business School in Nice.
Scenario analysis is increasingly being used by financial institutions. It is one of the key recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) and is also part of the reporting standards drawn up by the International Sustainability Standards Board (ISSB).
EDHEC’s assessment of UK pension funds found the scenarios they used were in some instances “presented with one hundredth of a percentage point precision, which gives the impression that we can know things with complete accuracy. Common sense will tell you that is not the case”.
With climate change, “we clearly have a very uncertain situation, with some outcomes that can reasonably be expected to be very severe”, he argued. However, many scenarios predict it would have “an extremely small impact onfinancial portfolios”.
Similarly, many of the scenarios developed by the UN’s Intergovernmental Panel on Climate Change (IPCC) are not fit for use by investors – yet are commonly used by them.
One of the biggest drawbacks is that the IPCC has failed to assign probabilities toeach scenario, so it is not clear what is most likely to occur – and thereforedifficult for investors to know which course to take.
While “it makes sense for policymakers to err on the side of prudence” and decide policy based on the worst-case scenario, when it comes to investing, “there’s no right way to be wrong”, Rebonato argued. “If an investor is too conservative or too aggressive, then the portfolio will suffer.”
Investors therefore need to know how likely a scenario is to occur – as well as the limitations of the scenarios they are using. “Knowing that your returns are more uncertain changes your investment decisions, so this needs to be communicated better so investors can make appropriate decisions”.
Rebonato is currently involved in the development of a climate risk scenario, specifically for investors. This aims to better calculate and outline the probability of risks occurring, so investors can further understand the uncertainty associated with risks in their portfolio.
However, he argued that better understanding of uncertainty is not only the responsibility of scenario developers, but also the investors themselves.
“Unfortunately, there’s so much information that board members receive that they want everything reduced to a single number or traffic light system,” Rebanato said. “[But this is] totally inappropriate for climate change because we’re in unchartered territory, so we need to engage in a much more complex way”.
While investors need to be provided with better quality information, the “decision-maker must also be willing to do more homework”.
Failure to engage meaningfully with the limitations of current scenarios means that the “market is not fully recognising the potential impact of climate risk – and this situation cannot continue”.
While the extent to which current investments are based on faulty scenarios cannot be known, Rebonato warned that it is more than likely that a lot of market valuations do not adequately account for climate effects and it is “difficult to know when a correction might take place”.
The market has faced wrong valuations before, such as the 2008 financial crisis, or major shocks such as Covid, but the market “typically bounces back”. With climate change, “there’s no natural rebound”, to the state of play beforehand.
“While the climate shocks might not be as severe immediately, they might not reverse, which can be difficult to predict,” he argued.
Rebonato is part of a team at the Risk-Climate Impact Institute, made up of academics, scientists and former financial practitioners, which is developing its own climate scenario specifically for investors. It expects to have the preliminary results of its analysis within a couple of weeks, with aims to have an initial version ready to share publicly in the next few months."
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Investors' scenario testing not recognising full climate risk, warns academic
About EDHEC
Operating from campuses in Lille, Nice, Paris, London and Singapore, EDHEC is one of the world’s top 15 business schools. Fully international and directly connected to the business world, EDHEC commands a strong reputation for research excellence and the ability to train entrepreneurs and managers capable of breaking new ground. EDHEC functions as a genuine laboratory of ideas and produces innovative solutions valued by businesses. The School’s teaching is inspired by its research work and a focus on “learning by doing”, all with the aim of equipping people with the skills to succeed in business.
