The Biggest Problem with Climate Risk Management in Finance

This article is taken from a discussion held between Intuition and three industry leaders on the area of climate change in the world of finance.

In this part of the discussion, Paul Fisher, a former Bank of England Executive Director, EU High Level Expert Group and UK Green Finance Task Force member, explains what he sees are the limitations with climate stress testing and risk management as a whole.

Some other articles taken from the discussion are:

Sustainable Finance: How is the Regulation Progressing?

Global Warming and Climate Change – The Impact of the Real Economy

Paul Fisher:

The main problem we’ve got is this:

Most risk assessment, the whole of the risk industry, is backward looking. They’ll take the data set, they’ll look at what the risk of default is, what’s the exposure at default, what sort of loss might be made on that default etc. That’s the standard credit risk model.

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Or they’ll conduct a value at risk analysis of market prices and look at their data set and determine what is the most they’ve lost on a portfolio of equities like this in a particular 30 day period for example. They’ll then calculate these risks. It’s a pretty bad way to do risk management, but it’s a fairly standard technique.

The problem we have with the climate is the temperature is still warming and as a result the issue is still growing. We haven’t yet seen the full range of consequences from the ever-rising temperature of the planet. Financial datasets do not encapsulate the risks we are going to be facing. They just aren’t capable.

No backward looking data analysis that doesn’t take into account these trends is going to be adequate for managing risk. You have got to be forward looking. You have got to extrapolate. You have got to imagine scenarios that could possibly happen.

Human beings are terrible at looking forward. We’re quite good at doing it in science fiction books, but we’re not very good at doing it in things like risk management and our everyday lives. To imagine that something bad might happen, that has never happened before, is almost inconceivable for humans.

Every year, we get these never before seen events crystallizing. For example, in 2021 we had the warmest March day on record in the UK.

Stress testing is just one way of looking forward – scenario analysis is a key part of the recommendations of the task force on climate-related financial disclosures for that very reason, that need to be forward looking.

Thomas Verhagen:

This is interesting. I hear you say people, by their very nature, are not accustomed to taking on this forward looking approach. One interesting point to note here is to extrapolate from our current knowledge base and become more forward looking financial professionals, we must learn new skills and expand our knowledge. The more knowledge we have of the past and the present, the better we are at predicting the future.