Pension funds are risking the retirement savings of millions of people by relying on flawed climate economics, warns a report from the financial think tank Carbon Tracker and Professor Steve Keen.
- Researchers warn that economists are not factoring climate science, or related impacts and tipping points, into scenarios and risk analysis.
- The most common economic models used, the DICE models, are based on self-selected assumptions and downplay potential risks. The impact of this summer’s heat should be a warning, with up to 60% of southern Europe’s crops at risk.
- Pension fund trustees could be liable for not requiring sensitivity analysis and a deeper understanding of the risks – climate risk could be a repeat of the 2008 financial crisis.
The report warns that financial institutions, central banks, regulators and governments underestimate the dangers and economic damages of climate change, relying on research from a small, self-referential group of climate economists that ignores the impact of climate ‘tipping points’.
The report reveals that many pension funds use investment models that predict global warming of 2- 4.3°C will have only a minimal impact on member portfolios, relying on economists’ flawed estimates of damages from climate change, which predicts that even with 5-7°C of global warming economic growth will continue. The report underscores that such economic studies cannot be reconciled with warnings from climate scientists that global warming on this scale would be “an existential threat to human civilisation”.
Perhaps what is of most concern is the fact that such models also affect international agreements and domestic policymaking. The Financial Stability Board (FSB) predicts that a 4°C rise in global temperatures would reduce global asset prices by 3-10%, while the Network for Greening the Financial System (NGFS), which has over 130 central banks as members, projects that 3.5°C of warming could reduce global GDP by 7-14% in 2099. Even the Intergovernmental Panel on Climate Change concluded in a 2022 report that 4°C of warming would reduce global output in 2100 by only 10-23%.
This argument, that the impacts of climate change will not have a catastrophic financial impact (let alone the human) seems to be what is allowing policymakers and investors alike to take a wait-and-see approach. There is broad talk about net zero targets, disclosure and transparency, but very little urgency seems to have made it into the thinking of economists or the investors who listen to them.
Criticism of the current economic models underpinning climate scenario analysis
The Dynamic Integrated Climate-Economy (DICE) model is an integrated assessment model (IAM), which acts as the basis for much scenario modelling used for climate stress tests. It was developed by Nobel Laureate William Nordhaus that uses a neoclassical economics approach, supposedly integrating the carbon cycle, climate science and estimated impacts.
The challenge is that such models are ‘simple’ in that the way in which they model the environment and human systems (as well as the ways in which they interact) in very simple ways. For example, they don’t integrate the latest climate science, ignoring the potential impact of climate tipping points. At the same time, they estimate impacts based on subjectively selected costs and benefits of taking action on climate change. That makes their efficacy completely dependent on the inputs selected by economists — who are failing to integrate their work with the latest climate science.
Many are missing the most basic data, report author Professor Steve Keen says: “[These are not models that] take climate science from the outside. Thirty years later no one has added precipitation to any of the models and or do economic assessments on what happens when the weather gets warmer.”
What about missing climate ‘tipping points’?
While it’s worrying to note that economic models of climate impact aren’t looking at the potential impact of widespread drought and or flooding, there is another concern that is being ignored.
Scientists warned in 2022 that several tipping points risk being triggered in the next decade. For example, the loss of winter ice in the Barents Sea and the collapse of deep convection in the Labrador Sea could lead to more extreme seasonal weather in Europe, worse than experienced during the Little Ice Age, with significant sea level rise on the northeast seaboard of the US.
A recent report in Nature warned that the (less than excitingly named) Atlantic meridional overturning circulation (AMOC) could shift as soon as 2025 – the prediction is between 2025 and 2095. This is the ocean system that takes warm water from the tropics to the North Atlantic and a shift in its workings could have a dramatic impact on lands available for crop growth. While it is impossible to know exactly when that shift might take place, wouldn’t it be common sense to assess what impact such a shift might have?
What matters is that these ‘tipping points’ are not taken into account in the economic studies being relied on by the mainstream investment models used by financial institutions, as highlighted in a recent report by the Institute and Faculty of Actuaries and the University of Exeter.
The Carbon Tracker report is not the first to criticise the use of these models. They don’t address the complex interaction of climate events and don’t represent the complexity of human response – but the real challenge has been the lack of transparency around input assumptions. There have been a number of concerns raised over the years, as pointed out in a 2021 report in the journal Globalisations, which include “technical disputes regarding appropriate quantities for variables to more fundamental critiques of the assumptions, concepts and purposes” of Integrated Assessment Models (IAMs).
Understanding the methodology behind the report
Professor Keen analysed the IAMs used by climate economists to estimate the future economic damages of climate change, assessed the empirical literature cited as inputs to the IAMs, and compared and contrasted these against the latest climate science, with a focus on impacts which the models commonly ignore – including climate tipping points, and more appropriate damage functions to model GDP impacts.
Carbon Tracker sent Freedom of Information Act requests to more than 100 local government pension schemes (LGPS) and pools in England, Wales and Scotland, to assess the extent to which their management of climate risks, investment strategies and asset allocation decisions appear to be influenced by external investment consultants. Around 80% of LGPS funds use investment consultants, with Mercer working with 50% of the LGPS sector.
What is the difference in impact of scenarios?
Investment managers and consultants such as Aon Hewett, Hymans Robertson and Mercer continue to rely on flawed research when they advise pension funds on the impacts of global warming on members’ portfolios. For example, Mercer in advice to Australian fund HESTA predicts only a -17% portfolio impact by 2100 in a 4°C scenario. It explicitly states that its model primarily reflects coastal flood damage and does not take into account climate tipping points.
Mercer itself also advises LGPS Central, which manages £55 billion of retirement savings for a million members of Local Government Pension Schemes in the UK. One of these schemes, Shropshire County Pension Fund, told members that a trajectory leading to 4°C by 2100 would only reduce annual returns by 0.1% by 2050.
In a 2022 report, Australian superannuation firm Unisuper concluded that even in a “worst case scenario” involving a 4.3°C increase in global temperatures by 2100 “the overall risk to our portfolio is acceptable”.
The report warns: “Each layer in the process of assessing the risks of climate change has assumed that the previous layer has done its job adequately, and has relied on the previous layer’s reputation, rather than scrutiny of the work undertaken. Pension funds rely upon consultants because of their reputation in the field; consultants rely upon academic economists, because their papers had passed (academic) refereeing.” The final impact is a series of flawed economic assumptions informing pensions’ decision-making.
That’s something that should be of significant concern to those hoping to draw those pensions in thirty years time. As Tony Burdon, chief executive of Make My Money Matter, said: “This report shows that the climate models used by our pension funds are not only implausible – they’re dangerous too. This so-called ‘expert advice’ is underpinning the investments of millions of UK savers, yet is jeopardising both our pensions and the planet.”
Ignoring climate risk puts the economy at risk like mortgage repackaging did in 2008
According to Mark Campanale, one of the founders of the Carbon Tracker Initiative: “Pension funds should assume much bigger asset value impact with global heating. At 2-3 degrees, they need to start looking at what happens if governments intervene and switch off.”
Pension funds have a fiduciary duty to correct the methodologies on which they rely, as well as the information they have given clients. The report says: “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.”
It concludes: “This report is a call to all stakeholders, from governments, regulators, investment professionals, all the way to civil society groups and individuals, to ensure that the critical error of taking this unsound (economic) research seriously is reversed, before it is too late. Climate change policy should be based upon the work of scientists, rather than the small group of economists who have worked on climate change, and “must be treated as a potentially an existential threat, rather than an issue which is suitably addressed by economic cost-benefit analysis.”
Advisers, consultants, and asset managers continue to underestimate just how exposed the financial system is to climate change. Pension fund managers should be requesting sensitivity analysis from asset managers to understand the realities they face, and central banks should be working out how to provide a buffer for short-term transition if that becomes the reality we face.