14 minute read
Environment: Playing our part
Features Environment
You’re going to hear a lot about COP26 this year, but what is it? COP stands for Conference of Parties, which is a conference where the world’s countries come together to set out actions against climate change. The 26th COP will be held in Glasgow in November, having been postponed from 2020.
COP21, held in Paris in 2015, was pivotal. In an almost unprecedented display of global unity, 197 countries signed the Paris Agreement. The agreement aims to hold the increase in global temperature relative to pre-industrial times to well below 2°C – thought to be the maximum temperature change that our global society might be able to adapt to. The increase so far has been 1°C, so there’s not much room left for manoeuvre. As global warming is driven by emissions of greenhouse gases (GHGs), emission levels must be drastically reduced if we are to have a reasonable chance of achieving this objective. In essence, we have a global carbon budget; if we go over budget, we’ll almost certainly have more climate change than we can manage.
As part of the process, each country agrees to a nationally determined contribution (NDC), which expresses its commitment to decarbonisation. The NDCs recognise that the pace of decarbonisation will vary between countries, but that total worldwide GHG emissions must remain within a global carbon budget for the collective eff ort to be eff ective. The fi rst round of NDCs were not enough – it is estimated that they will result in 3.7°C of warming, well over double the implied Paris goal of 1.5°C (the usual interpretation of “well below 2°C”).
Countries will be updating their NDCs at COP26, which is why it’s so important – it’s a chance to get things right. Much has changed since COP21. Public concern around sustainability and climate change are at high levels as the physical impacts of climate change become more visible. Globally, politicians are committing to net-zero policy objectives to mitigate climate-related physical risks and to accelerate the global energy transition. In the US, the Biden administration is clearly pursuing quite a diff erent climate policy to the Trump administration. There is signifi cant hope that politicians will collectively agree to more NDCs that are ambitious enough to meet the goals of the Paris Agreement.
In the lead-up to COP26, Louise Pryor and Sandy Trust set out the pivotal role actuaries have to play on the journey to sustainability
Features Environment
Where does net-zero come from?
One obvious question we could ask about the dual temperature goals of the Paris Agreement is: Does it actually matter if we limit global warming to 2°C or 1.5°C? The answer is: yes.
The Intergovernmental Panel on Climate Change issued a Special Report on 1.5°C of global warming in 2018. In this report, the global scientifi c community found that the extra half degree of warming would increase climate impacts signifi cantly. For instance, it could be the determining factor in whether coral reefs will continue to exist, and whether Mediterranean regions will become deserts. The report also set out the decarbonisation trajectories required to limit global warming to 1.5°C in a set of four scenarios, referred to as P1 to P4. Of these, P3 and P4 are widely thought to lack credibility as they rely on signifi cant levels of carbon capture and storage after 2050, using technology that hasn’t yet been invented.
P1 and P2 both require 50% or 60% reductions in GHG emissions by 2030, with ‘net-zero’ emissions by 2050 – a situation where the Earth system naturally absorbs at least as much GHG as our society emits.
The report has led to ‘net zero’ becoming the rallying cry for climate action this year, with many corporates and fi nancial services fi rms making net-zero commitments to complement those made by politicians.
Does the IFoA support net zero?
The IFoA issued a climate change statement in January, recognising that the climate is changing due to human activity and calling out climate change as one of the greatest risks facing the world today. The statement suggests that the best value insurance premium society can pay is to reduce our emissions today, in order to avoid the irreversible consequences of unmitigated climate change tomorrow.
To support the net-zero goal, the IFoA commits to advocating for policy frameworks that aim to achieve the objectives of the Paris Agreement, and for the development of eff ective methods for incentivising GHG reductions. A key course of action for the IFoA and its members is to use our actuarial skillset and infl uence to help equip the wider global fi nancial services markets, so that they can accelerate into a just and sustainable net-zero transition.
What role can and should actuaries play?
One of the lesser-known aspects of the Paris Agreement is the goal to make fi nance fl ows consistent with a pathway towards low GHG emissions and climate-resilient development. While GHG emissions physically drive global temperatures, fi nancial systems play a huge role behind the scenes because every pound that is lent, spent or invested has a realworld impact.
Actuaries are pivotal in the fi elds of pensions and insurance, and increasingly in banking, too. These industries directly infl uence what the future will look like, as they determine what sort of activities are fi nanced and insured. In the UK, for example, approximately a third of total investments are related to pensions. In other words, the decisions we make about how to invest these funds can make a profound diff erence.
However, this will require a mindset shift for us. We must consider not only the direct fi nancial impacts of our decisions, but also the broader real-world impacts that could have long-term eff ects on customers, shareholders and wider society. We must consider the fi nancial system not as separate from the wider Earth system, but as intricately linked to it. Money cannot put right the fundamental changes that climate change might bring after it is too late – but the fi nancial world can help keep it from getting too late.
We will need to adapt our actuarial toolkit so that it embraces new concepts such as systems thinking, sustainability, risk interconnectedness and net zero. We will also need to evolve our sense of responsibility, recognising that we wield great power through the decisions we oversee in the global fi nancial system – we have the power to make choices today that will have far-reaching and profound LOUISE PRYOR implications for is a sustainability tomorrow. Now actuary and is the time for president-elect of us to update our the IFoA operating manual and incorporate long-term sustainability into the tenets of the profession.
We actuaries SANDY TRUST have an immense leads EY’s opportunity here. Sustainable Finance We can play a part Consulting team and in securing a is deputy chair of the sustainable future, IFoA’s Sustainability ensuring pensioners, Board policyholders and society at large will have a world worth living in. And we must choose to do so.
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Climate change presents a material fi nancial risk, and it will impact the work that actuaries carry out. One of the key challenges in incorporating climate limate change presents a material fi nancial risk, and it will impact the e work that actuaries s ca c rry y ou o t. One of f the key cha h llen e ges s in i incorporating climate considerations is the time horizon over considerations is the time horizon over which they emerge. which they emerge.
Physical risks Physical l ris i k ks
While the physical impacts of climate While the physical impacts of climate change are expected to emerge outside of change are expected to emerge outside of the time horizons for business planning, the time horizons for business planning, the actions that are needed to avoid these the e actions that are needed to avoid these long-term risks need to be taken now; this long-t - er e m m risks need to o be b tak a en now; thi is has been referred to as the ‘tragedy of the ha h s been r f eferred d to as the e ‘tragedy of the horizon’. Unless the world takes decisive hori r zo on’. Unless the world takes decisive e action immediately, physical risks will start action immediately, physical risks will star a t to emerge gradually during this century. to emerge gradually during this century. While this is too late to impact our While this is too late to impact our assessment of physical risks next year, the assessment of physical risks next year, the choices we make in that year will infl uence choices we make in that year will infl uence those long-term risks. those long-term risks.
Consider the market price of a property, Consider the market price of a property, which represents the discounted future which represents the discounted future expected value that will be derived from expect c ed value that will be derived from the asset. The more frequent and severe the asset. The h more e frequent and severe weather events associated with climate we w athe h r events ass s oc ciated d with climate change will lead to an increase in the future change will lead to an n increase in the future costs involved in repairing additional costs involved d in repairing additional damage or even abandoning the asset; this damage or even abandoning th he asset; this aff ects today’s value. Today’s impact will aff ects today’s value. Today’s s impac a t will depend not only on the size and timing of depend not only on the size and timing of these future costs, but also on the likelihood thes se e futu ure cos o ts, but also on the likelihood that these events will happen. If consensus that these eve ent n s wi w ll happe p n. If conse ensus were to build that the world is on a severe we w re to o buil i d d th t at t the world is on a severe e warming pathway, then the adverse impact warming g pa p th hway, then the adverse impact on the asset value may be recognised sooner on n the h as ss s t et v l al a ue may a be e re reco c gn ng ised sooner and potentially suddenly, as investors refl ect and d po p te entially suddenly, as inves e t tors reflect the increased likelihood of climate-related th ht e e in i cr c ease ed d li ike ek li iho hood of climat tee re r la ated d future costs. f futu ure r cos o ts.
Transition risks Transition risks
The likelihood of physical risks can be The likelihood of physical risks can be reduced by taking strong co-ordinated reduced by taking strong co-ordinated action to move away from a high-carbon ac a tion to o mo m ve e awa ay y fr f om mo a hig i h h-carb r on n economy. However, this leads to transition economy. However, this leads d to t transiti t on risk. Given the urgency around addressing risk. Given the urgency around addressing climate change, we can expect transition climate change, we can expect transition risks to emerge sooner than physical risks, risks to emerge sooner than physical risks, but the time horizon for when they may bu b t t the e time horizon for when they may emerge is also very uncertain. emerge is also very uncertain.
Transition-related market impacts do Transition-related market impacts do not always emerge through the actual not always emerge through the actual implementation of regulations – they may implementation of regulations – they may arise from changes in consumer sentiment, arise from changes in co onsumer sentiment, or just from an increased expectation that or just t from an n in ncrea ase s d d ex xpe ect tat tion that t these regulations will be put in place, which these e regu g la ations will be put in place, which h can shorten the time horizon. can shorten the time horizon n.
For the global economy to transition, For the global economy to transition, concerted joined-up action is needed. concerted joined-up action is needed. However, current global progress on Paris However, current global progress on Paris Agreement commitments falls signifi cantly Agreement commitments falls signifi cantly short of the emissions reductions required short of the emissions reductions required by that agreement. This increases the by that agreement. This increases the likelihood of systemic costs arising from a likelihood of systemic costs arising from a failure to mitigate climate change. There is failure to mitigate climate change. There is a further risk that this outcome is refl ected a a further r risk that t this outcome is refl ected suddenly by markets, increasing disruption. suddenl ly by ma k rkets, increasi ing disr ruption.
Investments and risk exposure Investments and risk exposure
Conversely, investments in high-carbon technologies may seem attractive today, but they are likely to underperform in a strong mitigation scenario. Furthermore, these investments prolong support for carbonintensive business models, delaying the transition and increasing the chance that we remain on our current climate pathway – entailing associated future adverse fi nancial impacts and wider societal costs. Investment choices made today impact Investment choic ces made e toda d y impact exposure to climate-related risks and ex xposure to climate-related ri isks and d also infl uence their likelihood. Investing also infl uence their likelihood. Investing in ‘green’ assets might be predicted to in ‘green’ assets might be predicted to produce lower returns based on nonproduce lower retu t rn ns based on nonclimate aware valuation techniques, but clim mate e aware valuat tio i n te t chniques, , but t these investments are likely to outperform th hes se e in i ve v st s me ents are likely to ou utper re form m in a strong mitigation environment with in n a strong g mitigation o env n ir i on nment wit i h h high carbon prices and other measures. hi h gh car a bo on n prices s and oth t er measure es s. These assets also directly reduce the risk of These e a asse ets al lso di d rectly y reduce th he e risk of f a failed transition to a low-carbon economy. a a f faile ed d trans sn it iti io on n to a low o -c car arbo b n n econ nomy.
Conversely, investments in high-carbon technologies may seem attractive today, but they are likely to underperform in a strong miti t ga g tion scenari r o. o Furthermore, these invest tme m nts s prol lon ng g su s ppor rt for ca c rb bonintensive business models, delaying the transition and increasing the chance that we remain on our current climate pathway – entailing g associated future adverse e fi fi nancial impacts s and d wider r societal costs.
Incorporating climate risks Incorporating climate risks
To understand and manage the risk attached To understand and manage the risk attached to any form of projection, we need to to any form of projection, we need to understand the climate assumptions un nderstand the climate ass s umptions underlying the modelling. The one thing underl i ying the e modelli l ng. The e on o e e thing g we cannot do is ignore climate impacts and we cannot do is ignore climate impacts and assume that we can continue on our current assume that we can continue on our current path without consequence. Actuaries need path without consequence. Actuaries need to recognise the balance between physical to recognise the balance between physical and transitional risks in their work. Future and transitional risks in th hei ir work. Future projections are always uncertain; we need projections are always uncer rtain; we need d to understand and communicate the to understand and comm municate the uncertainty, including how climate could uncertainty, including how climate could d aff ect the outcomes. aff ect the outcomes.
WENDY
WALFORD is an actuary working in risk management at L&G and a member of the IFoA Sustainability Board
EVENT HORIZONS
Wendy Walford explores the emergence and interaction of climate risks over different time periods, and discusses the implications for actuarial work
