Climate risk and financial risk

October 22, 2022

Systemic risk and climate change strongly affect each other. Unfortunately, a lot of research promising to tell how, does no such thing. Because of a fundamental misunderstanding of what risk is and how financial institutions operate.

Much of valuable research considers the intersection between financial risk and climate change. The nexus between the two is clear. Decisions made by financial institutions can mitigate or accelerate climate damage; likewise, environmental risk will increasingly impact systemic risk.

Unfortunately, some research into the climate-finance nexus is marked by two conceptual flaws

The first relates to the nature of risk.

Climate change and the probability of adverse outcomes — climate risk — happens over many decades, even centuries. We will not suffer the worst in the short and immediate term, perhaps global warming turning large parts of the earth into a wasteland or rising sea levels flooding low-lying cities.

The decisions that affect these scenarios are made today. However, the realisation of the adverse event happens far into the future. It is the same with systemic financial risk. The time between decisions and outcomes can be very long, while the financial and political benefit of doing nothing today often trumps mitigating future disasters.

A sensible analytic framework for the climate-finance nexus should consider that. Conceptually, a multidimensional stochastic model, where

1. The lead-lag time between actions and outcomes is measured in decades;
2. Model the political and financial pressures that prevent mitigation;
3. The distribution of outcomes is thin Pareto tails and with low volatility today;
4. Volatility increases and lower tail fattens as time passes.

That is not how some research has it. Instead, the prevailing methodological approaches seem to be based on market risk technology, like 99% daily Value-at-Risk or Expected Shortfall, or perhaps their credit counterparts.

The problem is that risk, as captured by the 99% daily Value-at-Risk or Expected Shortfall, has no connection with either systemic risk or climate risk. The reason is that Value-at-Risk or Expected Shortfall and their ilk are designed to capture events that happen an average once every five months, where the event is not particularly damaging. In other words, these concepts of risk are made for the risk management of trading portfolios, hence the name market risk.

These market risk measurements have practically nothing to do with the long term. I discussed that in a recent post titled Why the risk you measure is probably not the risk you care about.

A mild adverse event that happens on average once every five months is simply on a different frequency than a multi decade catastrophic event, like climate change or systemic financial risk.

Why would someone then create models relating market risk to climate risk? One reason might be that some work has maintained that such market risk measures capture systemic financial risk. However, I don't think such work is generally taken seriously by systemic risk experts, even though some do, as I discussed in another post titled Who believes risk can be measured?

Another reason might be that there is plenty of high-frequency data, so it's easy to create a model.

The second conceptual flaw relates to how financial institutions operate.

Work I have seen often uses current asset holdings as a benchmark to measure the impact of the environment on financial institutions, and in the reverse, how current assets affect the environment, like investing in brown technology.

That is correct insofar as financial institutions fund today's economic activity that causes climate risk.

However, the reverse impact is not correct. A bank that funds brown firms is generally not at risk of such firms failing. The bulk of such funding happens via short and medium term credit (lending or bonds), and such lending will be repaid long before the calamitous environmental event.

Moreover, equity holdings are continually rebalanced and given the long time before the damage occurs, banks have plenty of time to trade out the brown and into green firms.

So

While it is certainly worthwhile to consider the feedback between bank assets and environmental damage, there is a right and wrong way to do such work.

When I have pointed out these two conceptual problems, the typical reaction seems to be, "yes, we are aware of this, but what can we do? It's a very important problem, and we have to do something."

Sigh.

Not only does it misdirect scarce resources, but even worse, it also gives ammunition to climate deniers.

There are ways to research the finance-climate nexus correctly. It will not be as easy as using market risk as one's risk concept. But doable and valuable. Why take shortcuts that are so easy to attack and undermine the mission?

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