Are we in a ‘delayed disclosure trap’?

The risk that better institutional climate risk assessments will not be done

Image by Prawny from Pixabay

A notable trend in recent years has been the recognition that climate risks have been underestimated.

This has long been recognised by many scientists, activists, and others. What’s different now is that this underestimation is being identified in the risk assessments undertaken by institutions that play a critical role in societies and globalised economic systems.

This trend is epitomised by the recent work of the UK Institute and Faculty of Actuaries (IFOA), the professional body representing and regulating actuaries in Britain.

Partnering with Exeter University’s Global Systems Institute, the IFOA have published a series of reports arguing that:

“climate change risk assessment methodologies understate economic impact, as they often exclude many of the most severe risks…They are precisely wrong, rather than being roughly right.”¹

In this post, let’s explore a potentially critical dynamic in the broad political economy of this trend: will anyone actually do better risk assessment?

Growing recognition

It’s not just the actuaries who are sounding the alarm about poor risk assessment. Other financial actors are taking note. This table from Schroders is typical. It shows that the economic models widely used to estimate the consequences of climate change expect scenarios of 4°C+ warming to only slightly reduce the trend rate of economic growth.

As the IFOA, innumerable Earth system scientists, insurers, financial experts, and economists (including Joseph Stiglitz) have pointed out, such scenarios would be biophysically catastrophic. Yet many economic analyses used by financial institutions, central banks, and governments expect global economic growth to largely stay on trend in these scenarios.

Concern at this discrepancy is graduating beyond finance. For example, in a recent report co-published with Chatham House, Exeter GSI, and the Institute for Public Policy Research, we at SCRI highlighted similar blind spots in the assessments undertaken by the national security elements of governments.

These blind spots are common across sectors, including the exclusion of tipping point risks, the failure to countenance scenarios of higher or accelerating warming, and the inaccurate portrayal (or omission) of cascading impacts and systemic risks. As a result, there is now constant surprise at the latest ‘once-in-a-lifetime’ weather extreme, the persistent presence of climate-induced inflation, and so on.

Enduring surprise is a sign of how poor climate risk assessment is holding back the situational awareness of key institutions. Poor assessments mean these institutions are failing to identify what is unmanageable and must therefore be avoided, like the collapse of the Atlantic overturning circulation, the consequences of which would be catastrophic. This is creating complacency about the ultimate threat posed by climate change, playing into sluggish decarbonisation.

We see this in the recent news that JP Morgan has stated that “we now expect a 3°C world”, citing “recent setbacks to global decarbonization efforts.” In turn, JP Morgan’s evaluations of its climate risk exposure make no mention of tipping points, cascading socioeconomic impacts, and all the other risks that raise serious questions about the stability of financial markets in a 3°C (let alone the 4.4°C scenario it considers in its climate risk assessments).

It’s not just about what is unmanageable and must be avoided. Poor situational awareness also hinders the ability to identify what might be unavoidable and must therefore be managed. This is one of the reasons that climate adaptation is so poor.

The need to improve situational awareness is why all the recent reports on the institutional underestimation of climate risk urge these institutions to adopt more suitable risk assessment techniques, like including tipping risks and cascading impacts, and focusing on worst cases (which is common practice in risk management).

In short, all the recent reports are asking that the full scale and implications of climate risk are finally revealed.

Truth hurts

It is of course important that this moment of revelation happens, as it might help precipitate far more urgent action to avoid climate worst cases by reducing emissions. Or at least spur political action from people horrified by the complacency, who might then create the conditions for more action.

But would institutions actually disclose the scale of climate risk we now face, even if they did undertake the kinds of risk assessments that these reports (and we at SCRI) are calling for?

Let’s explore a thought experiment. Consider an average English local authority pension fund. A recent report from Carbon Tracker and Professor Steve Keen showed that, in a 4°C scenario, these funds expect their climate risk exposure to amount to a ~1% loss. This is a scandalous underestimate.

A typical risk assessment from an English local authority pension fund. The ‘failed transition’ scenario leads to a global temperature rise of 4°C by 2100.

Now, let’s say that a fund had read the Carbon Tracker report and decided to do something about this, looking at a more ‘realistic’ 4°C scenario, which included all the major risks this entails. This would have to include things like AMOC weakening and collapse scenarios. Collapse cannot be ruled out this century, and severe weakening might have a higher likelihood than anticipated even at lower warming scenarios.

According to an OECD analysis, a collapse triggered at around a 2.5°C global temperature rise would be globally catastrophic for food production, wiping out well over half the suitable growing area of wheat and maize, which underpin globalised food systems.

AMOC collapse impacts for key crop growing areas. Percentage difference in crop suitability between no AMOC collapse (present day) and the effects of AMOC collapse plus 2.5°C of global warming. Decreases in suitability are represented with red shading, increases with blue. Source.

The cascading effects – on trade, financial markets, geopolitics, social cohesion, economic stability, and so on – would be disastrous. This would be just one possible event within the wider scenario of 4°C, which would also include the other impacts of climate change and nature loss and their cascading and interactive effects across the world.

The impacts of all this would impose losses far beyond 1% on the pension fund. The losses would be so severe that the estimated price in terms of GDP would be so high as to be meaningless. The world would be unrecognisable. Broken.

So, the fund would, in this new 4°C scenario, reach the conclusion that 4°C is existential for the fund. Incidentally, it might reach the conclusion that scenarios below 4°C of global heating are also existential, once the risks of tipping points, cascading effects, and so on are considered.

Delayed disclosure

Here comes the rub: what would happen if it released this information? If it did so unilaterally, the act of disclosure might have material impacts, shaking confidence in the fund.

Its stakeholders might respond in disbelief, losing confidence in the fund’s management, who could be (mis)labelled as doom-mongers. Or these stakeholders could punish the fund for sticking its head out, seeking the false reassurance of other funds that stick with the narrative that their portfolios were safe in a 4°C world.

A similar dynamic might occur if a group of funds did this. Or even perhaps if a regulator in one country mandated this be done within the confines of a domestic financial system. The sheer scale of the underlying climate risk could, in the act of disclosure, have a material financial effect, whether driven by disbelief, investor flight to purportedly ‘safer’ assets, or some other mechanism.

This thought experiment leads to a troubling conclusion: there might be a disincentive to disclose a fuller institutional assessment of climate risk exposure.

The immediate consequence is that the underlying risk then grows. By not disclosing a franker assessment, everything seems fine again. The world is on a trajectory for over 3°C of warming but the risk assessments say this will have a negligible effect. A 1% loss to a pension portfolio is easily manageable. So, investing in fossil fuels is ok. But this only increases the underlying risks.

Let’s then say a new generation of fund managers takes over and decides now is the time to disclose. In the meantime, the world has fully overshot 1.5°C. So, in undertaking a more realistic assessment, the new managers discover an even higher level of undisclosed risk. With it comes a greater disincentive to disclose. And the vicious cycle continues.

We could call this the ‘delayed disclosure trap’: that as undisclosed climate risk grows, the disincentive to disclose grows with it.

It goes beyond finance. For example, who, in a position of government, would want to incur the political costs of admitting the situation the world is now in and – crucially – be specific about these risks. It is one thing to use broad rhetoric about climate change being ‘existential’, another thing entirely to include the full socioeconomic impacts of AMOC weakening/collapse in an official government risk assessment. Such admissions might be shot down by other parties and/or cause genuine alarm and destabilisation. These are non-trivial political disincentives.

The persistent failure to disclose only one part of the trap. Improvements in science also contribute, by showing the physical impacts of climate change as manifesting at the extreme ends (or beyond) of what we thought possible, and often much sooner than expected. This is combined with the fact that societies are proving much more vulnerable to cascading impacts than was initially thought, at a time when other societal risks are escalating.

Breaking free

What can help break this trap? The actual manifestation of climate risk for one, but on a scale far greater even than what we’re seeing recently, such as some of the more globally destabilising risks that experts have been warning about, like multiple breadbasket failures.

Such events are outside the trend of a steady increase in isolated extreme weather events that anchors the unrealistic assessments of so many institutions. By destabilising globalised systems at a scale and pace similar to Covid-19, such events could lead to a definitive dislocation of expectation that forces institutional assessments to grapple with the underlying scale of climate risk. It would be clear that the world was on a non-linear trajectory of global-scale, climate-driven destabilisation.

Such a rude divergence from expected risk would be highly destabilising, not just because of the damage, but because of the potential panic and anger at such wide-ranging institutional failure. It might also trigger a ‘climate Minsky moment’, a sudden, destabilising market shift triggered by a reassessment of climate-related risks, leading to a rapid correction in asset values.

Instead, it would be better to break the trap in less painful and disruptive ways, through deliberate action on the part of governments, regulators, and key market institutions. Coordination is critical.

It could start with undertaking risk assessments that follow the principles set out in the reports by the IFOA and others; first at the heart of government, and then through sector-specific bodies, like regulators, both domestically and through international institutions and groupings. This would need a delicate strategy that coordinates multiple stakeholders to avoid early movers being punished.

Breaking the trap means removing the material penalties for climate risk disclosure, providing institutional guidance for how to respond, and even offering benefits for those who take the plunge. Strategies would need to manage the communication of this externally in a transparent and accountable way.

Greater candour is also needed from politicians and the leaders of other key institutions. Whatever your view on climate activism, the demand to ‘tell the truth’ is proportionate and materially important. The longer we don’t, the tighter the trap binds us.

Whether a managed escape from the delayed disclosure trap is possible remains to be seen. Climate risk is accelerating. Meanwhile, in some places, notably the US, institutional risk assessment capabilities are being eroded. Climate analysis bodies are being dismantled, and climate change has – for the first time in over a decade – been omitted from the federal government’s core threat assessment.

As has ever been the case, it will require political and institutional will to escape the trap by design, rather than by disaster.

1. Full transparency: I sat on the technical advisory group for the latest report (Planetary Solvency – finding our balance with nature) and am a GSI fellow.