A call for transparency in climate risk analysis

13 May 2020

Collaboration and a move away from black box methodologies are needed if investors are to have the right tools to manage climate risks, argues Stephen Fitzpatrick

 

E, S & G are entangled, in the real world. Social and ecological systems are tightly coupled, and the relationship between them is complex and non-linear. They are a 'mangle' as the philosopher of science Andrew Pickering puts it.

We can see this at a macro geopolitical level in the social push back against environmental policies from the Gilet Jaune movement in France. Elsewhere, populist leaders are responding to social pressure from industry lobbies by rolling back progressive environmental policies.

So much for geopolitics – what are the practical implications for the financial sector if we treat environmental and social factors not as siloes, but as tightly coupled?

For central banks, taking the E and the S as a mangle entails fundamental changes to social norms and modus operandi; it has both a technical and an adaptive, human and social dimension.

At a technical level it means the adoption of non-equilibrium models that can better account for non-linearity, uncertainty, political economy considerations and the role of money and finance.

As the authors of a recent book, The Green Swan. Central Banking and financial stability in an age of climate change point out, at a human, adaptive and social level this means that measuring, managing and supervising climate-related risks will only make sense within an institutional environment involving coordination with monetary and fiscal authorities, as well as broader societal changes such as a more systematic integration of sustainability considerations into financial and economic decision making.

This complex collective problem requires the coordination of actions among many players, including governments, the private sector, civil society and the international community.

Recognising the entanglement of E & S factors has implications that are no less radical for the way that ESG data providers and climate risk specialists, such as ourselves, must conduct ourselves if we are to provide our clients with reliable data, models and advisory services that will enable them to make sound decisions.

For us, this means taking social factors, such as commitments to open collaboration and radical transparency, as the enabling factors, without which realistic science-aligned environmental data and models simply aren't achievable.

Why so?  Two reasons:

  1. Open collaboration. Climate change is a complex, systemic, multi-faceted problem and no one has all the answers. With science and technology changing rapidly, collaboration with climate scientists, research bodies, academics and climate-risk focussed NGOs is essential.
  2. Radical transparency. Effective interdisciplinary collaboration goes hand in hand with a second social factor:  a radical approach to transparency. Scientific scenarios are based on different assumptions, so we need to know what these are. Without disclosure-based climate risk solutions, comparable analysis isn't possible. End users can't evaluate the accuracy of competing modelling methodologies and the results they generate without access to the underlying model's assumptions. Furthermore, as science progresses it's essential that the recalibration of models is communicated to end users so that trust is maintained.

How do social and environmental factors converge to deliver 'science-aligned' scenarios?

With the market departing from the notion of a pure assessment of a financial institution's present carbon risk exposure, investors are demanding to know how well prepared companies are for the low-carbon transition by incorporating forward-looking elements into their climate risk management, such as capex requirements, abatement technologies and carbon pricing impacts.

This is where scenario analysis and portfolio alignment come into play.

Genuine climate risk solutions need to continuously consult the scientific community to ensure that the climate science of their models is robust. Emission reduction requirements that achieve a certain temperature pathway or fit within designated carbon budgets are updated on a regular basis, so an open dialogue with the scientific community is paramount to ensure the quality of climate risk management tools for investors.

"Genuine climate risk solutions need to continuously consult the scientific community to ensure that the climate science of their models is robust"

As per our own discussions with lead authors of the 1.5°C IPCC report, scenarios are projections and not predictions of the global economy. This means that scenarios with different underlying assumptions are all useful to assess different realities.

Giving investors the option of analysing the portfolios against both IEA scenarios (with the known caveats around the underestimation of renewable energy uptakes and relevance of carbon, capture and storage technologies) and IPCC scenarios from the critical 1.5°C report (that focus more on lower energy demand, parallel achievement of SDGs and even exclusion of carbon capture and storage technologies) ensures as comprehensive and science-aligned a picture as is currently possible.

Covid-19 has taught us that science alignment, transparency about data and modelling, and collaboration between different disciplines – scientists, policy makers and national governments – can make the difference between life and death.

"If competition on the basis of standalone 'black box' solutions doesn't give way to open collaboration and radical transparency as the bedrock for science-aligned solutions, then the absence of joined-up thinking and acting may yet contribute to preventable and disastrous 'surprises', such as an ESG bubble or a climate 'Minsky moment'"

If this is the case for Covid, how much more does it hold true for the great disruption that is climate change? And what can we do differently now in order to help mitigate climate risk and head off the worst of what is to come for ordinary people, businesses, investors and the economy?

In the context of unprecedented and accelerating changes occurring in our social and ecological systems we can ill afford a multiplicity of different ways of assessing data and modelling that make evaluation of competing or contradictory claims impossible.

The adaptive challenges to social norms which govern the way financial actors have historically conducted themselves may yet prove to be as great, if not greater, than the technical challenges.

If competition on the basis of standalone 'black box' solutions doesn't give way to open collaboration and radical transparency as the bedrock for science-aligned solutions, then the absence of joined-up thinking and acting may yet contribute to preventable and disastrous 'surprises', such as an ESG bubble or a climate 'Minsky moment'.

Stephen Fitzpatrick is head of communications, culture and wellbeing at Urgentem.