When it comes to managing emerging risks from climate change, the financial services sector has many mitigation strategies in place. But a recent analysis says the current techniques aren’t considering the most severe impacts to come.

The Institute and Faculty of Actuaries (IFoA) and the University of Exeter has released a new report, “The Emperor’s New Climate Scenarios,” which looks at the current state of climate-scenario modeling within the financial services sector. The overall outlook: the sector is “significantly underestimating climate risk.”

Analyzing actuarial principles against the finance sector’s modeling practices, it found that the current techniques exclude many of the most severe climate change impacts. This is due to the fact that economists are using an outmoded model of a 3˚C rise in global average surface temperature. But this contrasts with the more dire predictions currently being made by scientists.

“It is concerning to see these same economic models being used to underpin climate-change scenario analysis in financial services,” writes Professor Tim Lenton, Chair in Climate Change and Earth System Science at the University of Exeter in the forward of the paper. “This jars with climate science, which shows our economy may not exist at all if we do not mitigate climate change.”

The key challenges:

Climate-scenario models in financial services are significantly underestimating climate risk – Real-world impacts of climate change, such as the impact of tipping points, sea-level rise and involuntary mass migration, are often excluded from economic models.

Carbon budgets may be smaller than anticipated for developing risks – A faster warming planet will drive more severe risks, further accelerating the rate of climate change, in which case budgets may be smaller than those we are working with and may now be negative for a temperature goal of 1.5° C.

Regulatory scenarios may be encouraging group-think – The current regulatory scenarios may be leading to a herd mentality, relying on previous model results instead of watching new data impacts.

To combat these challenges, the researchers offer a few paths forward:

• More education on the assumptions underpinning current climate models and their limitations
• Development of realistic qualitative and quantitative climate scenarios alongside regulatory scenarios, and
• Using current qualitative scenarios that reflect the emerging climate change realities, along with out-of-model adjustments to reflect uncertainties.

Click here to read the complete report.