The Invention of "Climate Risk" - Politically Brilliant but Fatally Flawed
Part 3 of the THB series on insurance and climate change
Today’s post is Part 3 in the THB series on climate change and insurance.
Part 1 focused on the surprising recent financial performance of the insurance industry in the context of fevered claims of its looming collapse due to climate-fueled extreme events.
Part 2 explained that the insurance industry was a small part of a larger emphasis on “climate risk” by the global financial community. “Climate risk” — a concept bespoke to the industry — was defined in terms of the economic impacts of extreme weather. Because “climate risk” was novel and missed by the scientific community, the argument went, new methods and models were needed to assess that risk.
That’s where we pick things back up today — today’s Part 3 looks closer at how “climate risk” was created in global finance, representing a fatally flawed but arguably brilliant political tactic seemingly aimed at compelling the outcomes of the 2015 Paris Agreement. The larger story here is the rise of a climate-risk industrial complex in the global financial community.
Today’s installment looks at three issues:
Extreme weather became the focal point, but the real world did not play along;
Physical “climate risk” and “transition risk” became self-justifying rationales for transformation of the global economy, led by the global financial community;
“Climate risk” was to be assessed via scenario analyses and new types of risks models — Both deeply flawed.
Let’s go . . .
Extreme weather became the focal point, but the real world did not play along
In popular discourse, climate change and extreme weather have long been associated with one another. For instance, 30 years ago, when I was a post-doc at NCAR working on hurricanes and floods, my boss brought to me the magazine1 below.
Efforts to connect climate change and extreme weather really took off in the mid-aughts around the time that Al Gore’s movie An Inconvenient Truth came out, hyping the connection in apocalyptic fashion — especially via 2005’s Hurricane Katrina.2 The climate advocacy community wanted to bring climate change home to people and extreme weather seemed the perfect vehicle. In many ways it is a renewable political resource, as photogenic (and sometimes destructive and tragic) weather extremes happen daily, somewhere.
There was a big problem with the strategy however — Mother Nature was not cooperating with detectable trends in most metrics of extreme weather. This reality was confirmed in the 2013 when the Intergovernmental Panel on Climate Change (IPCC) released its Special Report ion Extreme Events (SREX). That report found evidence for increasing warm extremes and decreasing cold, but not detectable trends in hurricanes, floods, drought and other phenomena. The SREX also confirmed our longstanding conclusion that increasing disaster losses were overwhelmingly driven by vulnerability and exposure, and not changes in hazards.3
When the Paris Agreement was being negotiated in the 2015, there was clear motivation to bypass the unhelpful IPCC and peer-reviewed research on which it based its conclusions. So, for instance, in 2014, the climate advocacy group Climate Central established World Weather Attribution to circumvent peer review and provide media friendly, but scientifcally dubious, linkages of climate change and the disaster that just happened.
In 2015, as documented earlier this series, the global finance community created another way to associate climate change with extreme weather with the creation of “climate risk” in finance.
The figure below, from a 2021 report of the U.S. Financial Stability Oversight Council (FSOC)4 illustrates how physical climate risks — defined as “chronic” and “acute” — were expected to “adversely affect economic and financial stability.”
“Climate risk” had arrived.
Physical “climate risk” along with “transition risk” became self-justifying rationales for transformation of the global economy, led by the global financial community
I don’t have any inside information,5 but I’d really like to think that the invention of the notion of “climate risk” within the global financial community was tactical, as it would have been absolutely brilliant as a political strategy, even if eventually fatally flawed.
The political brilliance of “climate risk” is for three reasons:
First — Consider that he two sides of “climate risk,” physical risk and transition risk, give the appearance of a balanced approach to responding to climate change and also not responding to climate change.
At the same time, the framing is clearly biased towards meeting the goals of the Paris Agreement. Here is the Advisory Scientific Committee to the European Systemic Risk Board in 2016:6
If governments make an early start in implementing existing pledges, a “soft landing” is likely. The transition to a low-carbon economy would be gradual, allowing adequate time for the physical capital stock to be replenished and for technological progress to keep energy costs at reasonable levels. . .
A late transition to a low-carbon economy would exacerbate the physical costs of climate change. Global warming, and its implications for the frequency and severity of natural catastrophes, is increasing with the stock of greenhouse gases in the atmosphere. As such, a late transition to a low-carbon economy will aggravate the costs of transition for, among others, general insurers, reinsurers and governments.
The Advisory Committee was comprised entirely of economists and included no experts in climate, extreme weather, or its impacts. Physical “climate risk” was thus apparently assumed to be detectable in — what else? — increasing catastrophe losses via Munich Re.
The political logic here is that a transition will occur and thus we can either make it gradual, lowering transition risk and physical risk — or instead, transition later in a hurry and haphazardly, incurring higher transition and physical risks.
Which option sounds better?
Second — “Climate risk” logic is supported by professional and social dynamics in which there is essentially no consequence for hyping or exaggerating climate change and its connections to extreme weather and its impacts. There was (and still is) a very strong scientific consensus by the IPCC, across the literature, and among experts in insurance and reinsurance that the overwhelming reason for increasing losses is more people with more wealth, in locations exposed to extreme events.
However, claims that “climate risk” was driving a dramatic increase in catastrophe losses could be made with no concern whatsoever that they would be challenged or corrected.
On the other hand, anyone perceived to be countering or correcting the hype faced severe consequences, even if they are aligned with peer-reviewed science and the IPCC.
I learned this lesson in 2014 just as “climate risk” based on disaster losses was first being promoted. I had published a highly visible article for Nate Silver’s 538 — actually mine was the first publication of his rebranded 538 site at ABC/ESPN — that was titled: Disasters Cost More Than Ever — But Not Because of Climate Change.7 Inconvenient.
The piece simply summarized the recent IPCC SREX report conclusions and relevant peer-reviewed literature. The response was fast and furious resulting in a cancellation campaign that ended my short stint at 538. Later we learned that effort was funded by billionaire Tom Steyer and carried out by the Center for American Progress, but I digress.
Third — Another aspect of the political brilliance of “climate risk” is that the global financial community, because of its power and access to wealth and capital, brought along with it an ability to convince or compel businesses and governments to join the campaign, whether they agreed with it or not. This is no doubt one reason why ESG governance centered on climate swept through the business world so rapidly.
“Climate risk” was a compelling tactic in climate advocacy. It also gave the burgeoning “systemic risk” institutions born in the aftermath of the global financial crisis an unquestioned raison d’etre. The political stars all aligned — at least for a brief time.
“Climate risk” was to be assessed via scenario analyses and new types of risks models — Both deeply flawed.
The logic of “climate risk” is more clearly illustrated in the figure below from a report of the ESRB in 2020. The figure maps physical “climate risks” (the red up arrow) and climate policy “transition risks” (the blue down arrow) alongside various carbon dioxide emissions scenarios to 2100.
Note that that the “sweet spot” in that figure above — where both physical and transition risks are minimized — occurs at ~2.5 degree Celsius increase in temperature (from preindustrial values by 2100). In Brazil earlier this month at COP30, the UN FCCC projected that the world, on current policies is headed for ~2.3 to 2.5C temperature increase by 2100.
This moderating of climate projections based on more plausible climate scenarios helps us to begin to understand why the rise of “climate risk” has run into some strong headwinds — or at least that part of “climate risk” grounded in outdated emissions scenarios.8 Looking back just a few years at justifications for “climate risk,” it turns out that in 2025, scenario-based “climate risk” has just evaporated.
A second approach beyond scenario analyses to evaluation of “climate risk” is “climate risk” modeling. Across global finance, it quickly became conventional wisdom that new approaches to risk quantification were needed, because the mainstream scientific community had either overlooked these risks or had not considered them in the world of finance.
Blackrock’s Larry Fink explained the need in 2020:
[L]ow sustainability firms and countries are more likely exposed to the negative consequences of broad-based sustainability-related shocks, such as climate events. Modelling such a risk is a challenge as it requires making assumptions about a firm’s or country’s exposure without a history to rely on.9
In order to spur creation of a market for “climate risk,” in 2022 under the Biden Administration the Securities and Exchange Commission (SEC) proposed a “climate disclosure” rule that would require corporate disclosures of “climate risk.” However, in order to disclose a risk a company would first have to characterize it.
The SEC estimated that it would cost companies more than $10.2 billion in new reporting costs to comply with the “climate risk” disclosure rule. More recent estimates of the market for “climate risk” suggest more than $12 billion in 2024 growing to more than $64 billion by 2030. Regardless the exact numbers — there is a lot of money to be made in “climate risk.”
The result?
Private climate risk modelers have been the beneficiaries of this gold rush. . . They are private entities vetting the soundness of everything from city infrastructure to financial portfolios. Their unregulated new products—vast troves of climate analytics, with little standardization—are already being used by federal agencies, incorporated into municipal bond ratings, and influencing how investors spend money.
If you create a large market for “climate risk” and require businesses and governments to incorporate “climate risk” into their day-to-day decisions, well, “climate risk” will be found.
So what’s the problem?
“Climate risk” models simply cannot do what they have been asked to do by financial regulators. Of course, sophisticated methods can be employed to develop precise-looking estimates of “climate risk” and firms and governments will pay handsomely for those estimates.
But do they mean anything at all?
That is where this series goes next, in Part 4 . . .
Comments, questions, critique, requests — All welcome!
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For THB’s younger readers — a “magazine” was a collection of Substack-like articles that were printed and collated into a single volume, delivered to your mailbox. Amazing!
I always point out that Gore’s poster for An Inconvenient Truth had Hurricane Katrina emerging from a smokestack at a power plant — It was spinning the wrong way for a Northern Hemisphere tropical cyclone. Whoops. But an apt metaphor.
That this conclusion is even contested is remarkable.
The FSOC was created in 2010, in the aftermath of the global financial crisis, by the Dodd-Frank Act to assess systemic financial risks. It is comprised of U.S. government federal financial regulators and is housed in the U.S. Department of Treasury. It does not regulate itself, but has a powerful agenda-setting function.
Anyone who was “in the room,” please be in touch on or off record.
The ESRB is the European Union’s equivalent institution to the U.S. FSOC — also created in the aftermath of the Global Financial Crisis and focused on systemic financial risks. The ESRB is hosted by the European Central Bank.
It is still an excellent piece!
Consider a 2022 consultancy report — funded by Bloomberg Philanthropies, a major champion of “climate risk” — extolling best practices by businesses that readily followed guidance to assess their climate risks: “For physical risks, companies typically apply a high warming scenario (e.g., RCP 8.5) as well as a lower or moderate-warming scenario (e.g., RCP 4.5).” The company they choose to highlight was American Airlines: “American measured its exposure to potential physical risks using a high emissions scenario to identify acute and chronic hazards that may affect its operations. . . It based future projections on the IPCC’s RCP 8.5 emissions scenario, which assumes essentially “business as usual” between now and 2100. American chose the high-emissions RCP 8.5 scenario chosen because it produces an up-to-6 degree C rise in global temperatures . . .”. If I were an American Airlines executive, I’d feel like a sucker.
Recall the claims that historical weather and climatology could no longer serve as reliable guides to the present and future.
Let's see, they made up an imaginary climate risk and then charged us for insurance that mitigates the imaginary risk? There was a time when that was called fraud, and people went to jail for it.
Roger
I hope that when you have completed this excellent series you can put them together as a single extended paper that would be an authoritative read that I and others can circulate widely.