In 2015, Mark Carney, then governor of the Bank of England, argued that banks and insurers had failed to adequately quantify the financial risks stemming from climate change. Soon after, central banks and prudential supervisors started to put pressure on banks to manage these risks. In recent years, risk models and credit ratings everywhere have been tweaked to turn climate change into a source of calculable risks.
In a recently published research article, we trace this ‘riskification’ of nature back to 20th century climate science and financial risk-modelling innovations. In the early 1990s, banks started developing increasingly sophisticated risk management techniques premised on quantifying the probability of losses. These developments started with the creation of the ‘value at risk’ metric by JP Morgan. It became part of banking regulation with the 1996 Market Risk Amendment of the Basel Committee, which for the first time allowed banks to use internal models to measure risk.
It is then not surprising that central banks and prudential supervision would turn to risk modelling in response to climate change, possibly the largest driver of systemic risk in human history.
Steady progress made over the decades
There has been relatively steady progress in quantifying climate-related financial risks. Starting in the 1950s, key developments in climate science led regional and local interpretations of the climate to be replaced by the idea of a global climate. These included the increasing use of satellites, computer models and the rise of Earth system science.
The quantification of climate-related transition risks has seen relatively rapid progress, largely due to the availability of simple metrics for outcomes such as carbon dioxide equivalent emissions. Although risk estimates require further forward-looking assumptions, these are readily available. Carbon taxation serves as a proxy that can be easily incorporated into economic models to measure the effects of possible climate transition policies.
Not all nature-related risks are as amenable to quantification. This is especially evident in the case of biodiversity loss. Starting in 2021, numerous attempts by central banks to quantify biodiversity-related risks have only been able to produce risk exposure assessments.
Quantifying biodiversity risk is more challenging
The first quantification of biodiversity-related financial risks was completed only in December 2023. There are major methodological and technical obstacles in using existing nature-to-macroeconomy models for such assessments. These include: (1) the limited use of global scenarios given the context-specificity of biodiversity loss; (2) the fact that many nature-economy and economic models do not account for the low- or non-substitutability of so-called ‘natural capital’; (3) the inability of computable general equilibrium models to assess the short-term impacts of nature loss, which can lead to implausibly optimistic projections of the economic impacts of nature loss; and (4) the fact that many financial models can only consider aggregate economy-wide impacts, whereas biodiversity loss will have pronounced sectoral impacts.
As we show in our article, these technical difficulties partly stem from intractable questions concerning how to measure biodiversity. The concept was developed, in part, to circumvent narrow definitions and a range of difficult questions – for example, about what to save or when species losses shift from being marginal to significant or catastrophic. These difficulties came with some preceding and competing concepts such as endangered species, wilderness and habitat.
Our analysis underscores the need for caution against excessive optimism in this domain. This has significant implications for policy-makers and financial professionals who work to integrate nature into financial risk assessments.
Focus on alignment
What, then, should be the way forward? Our research has examined transition planning and other forms of alignment-focused regulatory techniques. The idea of alignment is simple and goes beyond the regulatory frameworks’ focus on riskification. Rather than quantifying potential losses on individual assets, alignment is about whether a given institution is ready for plausible future scenarios.
The key gambit of an alignment-focused approach is to invoke obstacles to riskification as a justification for more interventionist prudential instruments. Because nature-related risks are hard to quantify and easy to miss, a financial institution that is not aligned with plausible transition and adaptation pathways is riskier than one that is.
Consequently, misalignment is itself evidence of excessive risk-taking. An alignment-focused approach includes adequately tweaked risk-models but also supervisory reviews of the business strategy, management expertise and incentive structures as well as disclosure of plans to investors.
For climate transition planning, the Basel Committee has already developed guidance on how banks should manage risk and what count as permissible assumptions regarding the future. The next big step is to put such requirements into place for biodiversity and other environmental dimensions of the financial system, allowing banks and insurers to develop adequate internal policies tailored to specific nature-related risks.
Jens van ’t Klooster is Assistant Professor for Political Economy at the University of Amsterdam. Klaudia Prodani is a PhD candidate at the University of Twente.
Read ‘Planetary financial policy and the riskification of nature‘ here.
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