Portfolio Losses from Climate Damages: A Guide for Long-Term Investors

Summary:

UK Local Government Pension Scheme authorities have experimented with reporting on their governance and management of climate risks, responding to challenges by non-governmental organisations and anticipating regulatory developments. Drawing on advice provided by investment consultants, their reports have included simulations of the impact of climate-related scenarios on investments suggesting that portfolios would only be marginally impacted, even in high temperature scenarios.

In this paper, the author discusses the (de)merits of the advice addressed to pension trustees and engages with critics who assert that pensions are being put at risk by the flawed research and groupthink of climate economists.

The research concludes that pension trustees have indeed been poorly served by their consultants. It also concurs with critics’ views that the estimates of likely portfolio losses due to climate change in the authorities’ reports are implausibly tame.

However, the research offers a different and more nuanced perspective about how these conclusions have been reached and the use of integrated climate economics models. Importantly:

• the DICE models, which were designed for policy design, have been inappropriately used for scenario analysis;
• their modularity means they can be modified to accommodate scenario analysis;
• there is a wide divergence of estimates by economists regarding the severity of climate damages, challenging the idea that groupthink has led to a tame consensus view.

The research exposes the failure to communicate the huge uncertainty in damage estimates as the most glaring flaw of the advice received by trustees and denounces the non-sensical precision with which some of these estimates have been presented.

Echoing recent and forthcoming scientific publications by EDHEC-Risk Climate Impact Institute, the paper endorses attaching approximate probabilities to climate scenarios. Professor Rebonato warns that not only pension consultants but also financial markets appear to be sleepwalking into the climate crisis.