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2 October 2019

Climate ‘risk’ vs ‘uncertainty’ in financial policymaking

Current treatment of climate ‘risk’ rests on false assumptions about the dynamics of financial markets and the environmental challenges we face.
12 highlights from 2022
By David Barmes

Current treatment of climate ‘risk’ rests on false assumptions about the dynamics of financial markets and the environmental challenges we face. To address this deficiency, an understanding of ‘radical uncertainty’ must play a greater role in financial policymaking.

Due to its mandate to maintain financial stability, the Bank of England now pays increasing attention to ‘climate risk’. This includes: (i) ‘physical’ risks, which refers to an increased frequency of extreme weather events, such as droughts, flooding, storms, etc.; (ii) transition risks, which refers to significant shifts in asset values and business costs due to policy or technology changes associated with the low-carbon transition; and (iii) ‘liability’ risks, which refers to increased compensation claims that will likely result from the other two types of risk.

Consequently, the Bank of England, and more broadly the Network for Greening the Financial System (which includes 50 central banks and supervisors worldwide), is devoting much effort to developing methodologies that are intended to measure these risks. This is also the central goal of the Task Force on Climate Related Disclosures, which hopes that climate risk-measuring methodologies will subsequently be adopted by companies for disclosure purposes. Just last week at the UN climate summit, Mark Carney focused on the need for widespread climate disclosure based on climate risk measurement, stating that “to watch, you need to be able to see”. 

Such developments are welcome to the extent that they signal an acknowledgment of the importance of integrating climate change considerations into the financial system. However, the sole focus on climate ‘risk’ rests on a flawed theory of finance and a misunderstanding of the nature of climate and ecological breakdown and its interactions with society. 

The Efficient Markets Hypothesis (EMH):

The EMH (also known as the Capital Asset Pricing Model, or CAPM) holds that asset prices reflect all information available to investors, assumed to be rational individuals that form identical, accurate assessments of the risk and future return of investments. Therefore, any fluctuations in asset prices must be the result of new information, and financial distress can only result from some outside shock, the risk of which is calculable. Although two of its key originators essentially disowned the EMH claiming that “the empirical record of the model is poor—poor enough to invalidate the way it is used in applications”, it remains the dominant theory of finance amongst neoclassical economists.

As a result, neoclassical economists do not see systemic financial instability as a policy challenge; systemic risk does not exist in a world of efficient markets. As mainstream economics critic Steve Keen puts it, they assume that “the financial system is rather like lubricating oil in an engine – it enables the engine to work smoothly, but has no driving effect” resulting in the belief that they can “ignore the financial system in economic analysis, and focus on the ‘real’ exchanges going on behind the ‘veil of money.’”

At least, this is seen to be the case as long as the risk of shocks to the financial system are continuously calculated and disclosed. If done so, asset prices are expected to adjust and allow the market to function smoothly. Thus, while some financial policymakers might not claim full adherence to the EMH, their focus on identifying and calculating risk from climate (or whatever else) is a direct product of the theory.

Radical uncertainty as the way forward:

While we use the concept of ‘risk’ when assessing something that has a calculable probability of happening, ‘uncertainty’ refers to aspects of the future which do not have any such calculable probability. In Post Keynesian economics, this type of uncertainty is referred to as ‘radical’ or ‘knightian’ uncertainty, after Frank Knight, one of the key economists to have made this distinction between risk and uncertainty in 1921.

In the very same year, John M. Keynes also wrote about this issue, arguing that the most important economic risks are not calculable. Rather, they are unresolvable uncertainties, often generated within the system, and likely made worse by the financial system. Therefore, from this perspective, there lacks any rational basis on which to value assets, and valuations are subject to significant and unpredictable fluctuations resulting from herd behaviours, collective panic, new trends, etc. Such fluctuations can subsequently have destabilising repercussions for the real economy.

Building on these (and other) insights, Hyman Minsky developed the financial instability hypothesis. Contrary to the EMH, this theory describes the financial system as fundamentally self-disequilibrating. Financial instability is endogenous, as conditions of stability give rise to increasingly risky behaviours.

Since the 1950s, the concept of radical uncertainty has been increasingly abandoned in leading economics journals (though it remained central to marginalised Post Keynesian economics). This has been closely related to the increasing mathematical formalisation of the discipline and a prioritisation of prediction over description, both of which require the reduction of unquantifiable uncertainties into quantifiable ‘risks’.

The financial crisis brought some revival of the concept of radical uncertainty in the mainstream. For example, former Bank of England Governor Mervyn King wrote a book largely devoted to highlighting the importance of radical uncertainty for financial policymaking. King is now co-authoring another book entitled “Radical Uncertainty: Decision-Making Beyond the Numbers”, coming out early next year. Yet the concept has yet to be incorporated into the work of central banks and supervisors, who seem to remain far more focused on trying to quantify risks rather than acknowledge unquantifiable uncertainty.

Climate risk or climate uncertainty?

Climate change (and ecological collapse) is a perfect example of radical uncertainty, and makes the adoption of the concept more urgent than ever, in both financial and broader economic policymaking. If we fail to acknowledge the radical uncertainty that this issue presents, the stakes are even higher than a financial crisis.

To be clear, there is of course no uncertainty about climate change being real and no uncertainty that it is driven by human activity. The point is rather that the way in which climate and ecological breakdown proceeds is characterised by non-linearity, tipping points, and feedback loops in a profoundly complex, interconnected and ever-changing biosphere. Specific details of when and how these ‘accumulated disequilibria’ of the environment will manifest themselves are fundamentally unpredictable (yet, again, the fact that they will manifest themselves is not at all in question).

The deepest uncertainty, however, results from the very fact that climate change is dependent on us humans. There is no scientific basis on which to calculate the probabilities associated with potential human responses to evidence / forecasts of climate and ecological breakdown, which could involve myriad social / political / technological changes, the potential consequences of which are also characterised by radical uncertainty. In this sense, climate change encompasses many classic sources of uncertainty, such as innovation and politico-economic transformations.

All this considered, there has never been a more apt example of where “it is better to be vaguely right than exactly wrong”. We know that climate change will inevitably impact the highly interconnected financial system in big ways. Do we really need to wait for inherently limited economic models to try to feed us precise (and probably wrong) numbers in order to take any action?

Towards a precautionary principle for finance:

Once we accept that we live in a world of radical uncertainty, a sole focus on measuring quantifiable risks appears severely misguided. Financial markets are simply not ‘efficient’, and no amount of disclosure will change that. Instead of placing all our faith in methodologies that attempt to measure climate risk, we must acknowledge these methodologies’ limitations and give way to a precautionary principle for finance.

The precautionary principle is a common concept in environmental policy and certain other fields, such as public health. It is the idea that where we lack knowledge on the potential repercussions of an action, technology, or policy, and there is a suspected risk that it could cause harm to the public and/or the environment, the burden of proof that it is safe lies with those seeking to implement it. 

The precautionary principle must be transposed to finance. Financial policymaking has much to gain from acknowledging that not all risks are calculable. While the knowledge we do have already justifies radical action on climate, the knowledge we don’t have is precisely what guarantees that disclosure alone is insufficient to address the systemic risk that climate and ecological breakdown presents to financial stability.

The specific ways in which such a precautionary principle would be best integrated into financial supervision remains to be seen. This is likely to be a fruitful topic for research in the coming years. For example, researchers from University College London (among others) are already developing work on this very question. At Positive Money, we’ll be keeping an eye on these developments. Central banks and supervisors ought to do so as well.

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