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Investment Reporting Models Must be Adapted to Climate Reality

Pension funds are relying on extremely flawed modelling to predict returns on investments. The modelling inaccurately suggests that the climate crisis will have no, or sometimes even a positive, impact on returns. Three reports have illustrated that these dangerous reporting models are impacting how pension funds make decisions about investing in fossil fuel projects, thus putting pensioners and the economies they rely on at risk.

Reports by Carbon Tracker, the Institute & Faculty of Actuaries and University of Exeter, and Economics of Energy Innovation System Transition at the University of Exeter are all aligned: investment consultants must support pension funds to change the way decisions are made regarding climate risk to investments.

…These predictions of the minimal economic impact of global warming of 2-4.3°C are representative of the advice being given by pension funds worldwide to their members. This advice is completely at odds with research by climate scientists, who are increasingly asserting that global warming is an existential threat to human civilisation, and at temperatures well below those contemplated by pension funds.

So, what should pensions do with this new information? The report by the Institute & Faculty of Actuaries and University of Exeter suggests that investment consultants and pension funds must focus on:

  • Educate staff on the assumptions underpinning the models and their limitations
  • Develop realistic qualitative and quantitative climate scenarios
  • Develop models to better capture risk drivers, uncertainties and impacts

Climate-scenario modelling is complex, but fear of imperfections cannot stop us from including the real threats of climate change in reporting.

To learn more about the solutions outlined in the reports, we’ve pulled out some toplines below.

Loading the DICE Against Pensions
Report by Carbon Tracker

  • Loading the DICE Against Pensions, written by Professor Steve Keen, a Distinguished Research Fellow at UCL. Keen was one of the few economists who predicted the 2007-8 financial crisis.
  • The report found that investment consultants — notably including global firm Mercer — gave advice to UK local government pension pool LGPS Central that a trajectory leading to 4°C by 2100 would reduce annual returns by just 0.1% by 2050.
  • Keen shows that the investment consultants come to their complacent and implausible conclusions by relying on the work of a narrow set of academic economists who review and endorse each others’ work – notably, climate scientists are not asked to peer review these findings. This practice that makes “scientifically false assumptions” ignores the likelihood of predicted triggering climate “tipping points” that accelerate economic damage.

The Emperor’s New Climate Scenarios
Report by Institute & Faculty of Actuaries and University of Exeter

  • Another report urging investing consultants to use climate-scenario modelling that relies on a deeper understanding of climate change, including tipping points.
  • The report asserts that climate-scenario models in financial services are underestimating climate risk:
    “Real-world impacts of climate change, such as the impact of tipping points (both positive and negative, transition and physical-risk related), sea-level rise and involuntary mass migration, are largely excluded from the damage functions of public reference climate-change economic models. Some models implausibly show the hot-house world to be economically positive…”
  • It also asserts that our understanding of carbon emissions is inefficient.
    “We may have underestimated how quickly the Earth will warm for a given level of emissions, meaning we need to update our expectations as to how quickly risks will emerge…A significant consequence of this is that carbon budgets may be smaller than those we are working with and may now be negative for a temperature goal of 1.5°C.”
  • And finally, firms are using regulatory scenarios as a way to hide without acting.
    “Key model limitations, judgements and choice of assumptions are not widely understood, as evidenced by current disclosures from financial institutions. Investors and regulators assessing financial resilience need to be particularly careful not to place undue reliance on artificially benign model results.”

Net-zero transition planning for pension funds and other asset owners
Report by Economics of Energy Innovation System Transition at University of Exeter

  • Report asserts that “current net-zero strategies guiding pension funds and other asset owners are too strongly influenced by modern portfolio theory.”
  • Modern portfolio theory is a backward-looking theory that is based on a view of financial markets that rests heavily on past investment returns. Climate risk is a forward-looking concept and must be treated as such.
  • Pension funds will play a critical role in the dramatic changes we need to tackle the climate crisis.
  • As one of the biggest pensions markets in the world, the report advocates that UK pensions must use “bespoke, ‘decision-useful’, scenario analysis.”
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