Climate Risk: A Black Swan No More
Climate change’s challenges are becoming increasingly commonplace and risk managers need to adapt.
Risk is everywhere. A bond might default, a trade war might shock oil prices, or a virus might sweep through the globe. Much of our economy has been built around containing risk: construction companies design buildings to specific resiliency standards, while actuaries, catastrophe modelers, and other quants put a price on potential hazards. Meanwhile, regulators and shareholders often require a quantitative accounting of risk as part of a company’s overall enterprise risk management (ERM) strategy.
As the U.S. Commodity Futures Trading Commission (CFTC) recently stated, “Climate change is already impacting or is anticipated to impact nearly every facet of the economy, including infrastructure, agriculture, residential and commercial property, as well as human health and labor productivity.” But an accounting of climate risk is lagging. Despite its potential for drastic impacts on companies’ finances and business models, it is rarely included in the risk management frameworks of the world’s largest companies.
The Task Force on Climate-related Financial Disclosures (TCFD) found in its 2018 Status Report that relatively few companies disclose the financial impact of climate change on their operations or business model. Furthermore, information on the resilience of their strategies under different climate-related scenarios is limited. Even companies that do make these disclosures need to include more actionable climate-related information.
While these risk assessments are largely optional for now, that is not expected to last. The CFTC report urges regulators to “move urgently and decisively to measure, understand, and address these risks.” Climate change preparation starts with an accounting of climate risk that goes beyond guesswork and qualitative assessments. Like other forms of risk, it should be quantified so that risk managers can prioritize immediate and future mitigation strategies in the context of both individual projects/assets and the ERM framework of the broader organization. Whether we are ready or not, the climate is already changing. It is time for organizations to adapt.
Black Swan Theory
Surprising events seem to happen constantly. The stock market lurches, a cluster of HIV infections emerges, a wildfire rages. After the event, we often rationalize: was this actually a surprise, or should we have seen it coming?
In recent years, black swan theory has emerged to categorize both the severity of the event and the severity of the surprise. In a 2007 book, finance professor and former stock market trader Nassim Nicholas Taleb defined its three key features: it is such a surprise to observers that its probability was never measured, it has a catastrophic impact, and in hindsight, it could have been predicted. The term was further popularized after he applied it to the 2008 financial crisis.
Black swans are so-called because they are allegedly unpredictable until they do, indeed, happen. Literal black swans were deemed impossible until they were discovered in Australia in 1697. Century-old financial institutions were assumed stable until Lehman Brothers collapsed in a day. These are the Unknown Unknowns: the event was inconceivable, let alone capable of being modeled.
With the rise of black swan theory came its relatives: grey and white swans. Grey swans are a bit more predictable: they are considered unlikely, but because we are aware of them, we are less likely to be blindsided by them and more likely to incorporate them into our planning. Hurricane Katrina, Brexit, and even the coronavirus fit here. They are our Known Unknowns: present in our consciousness, but still rare and difficult to predict. Finally, white swans occur regularly: heart attacks, house fires, and other events that an actuarial table can predict. We know that we know them.
Black Swans and Risk Management
Black swans are often called “silent risks” because they lurk, unknowable, until suddenly emerging. Many risks faced by the insurance and financial services industries were once silent. The first incidence of an utterly surprising event — the first pirate to take over a colonial ship carrying spices back from India, the first Category 5 hurricane to strike modern-day Florida, the first asbestos lawsuit — is labeled a black swan. But as we recover from the event and look to the future, we begin to understand it. We see the warning signs in hindsight, and we look for those warning signs elsewhere so that we can predict the next occurrence. Eventually, we build models and incorporate the new risk types into our day-to-day risk management framework. In this way, black swans transition to grey and sometimes even to white swans, the ugly ducklings all grown up. Liability, natural disaster, currency, contagion, and other risks have made this transition, with emerging risks like cyber not far behind.
Climate Risk: Another Black Swan?
So where does climate risk fit into this? For an answer, we can turn to the World Economic Forum’s annual Global Risks Reports. Published since 2007, the report quantifies the likelihood and impact of five categories of risk: economic, environmental, geopolitical, societal, and technological. Climate change first made an appearance in the top 5 of both likelihood and impact in 2011. In this year’s report, all of the top 5 risks by likelihood (extreme weather, climate action failure, natural disasters, biodiversity loss, and human-made environmental disasters) and 4 of the top 5 risks by impact (climate action failure, biodiversity loss, extreme weather, and water crises) have a climate component.
The cat is out of the bag, and it has been for some time. Climate change is already happening: the seas are already rising, and the US West Coast is already burning. We can start to approach its effects more like Known Knowns, both because our climate models have become more sophisticated and consistent and because we can see the early consequences of climate change with our own eyes. As climate change swiftly moves from black to gray to white swan, how should we manage the risk?
Managing Climate Risk
We’ve taken on new kinds of risks in the past. While Hurricane Andrew may have felt like a black swan event at the time, natural catastrophe models have vastly improved in the last 25 years, and the risk is now regularly modeled, priced for, traded, and managed. Furthermore, natural disaster risk has become regulated: probabilistic and scenario-based risk measurements are required by credit rating agencies and insurance regulators. It is slowly moving to the upper-right of the graph below.
Climate risk is not as far behind as it appears. It is not as unknown as pandemic risk or as unquantifiable as cyber risk; it is moving upwards and rightwards on the above chart. First movers are already profiting: climate-friendly mutual funds and indices, which avoid industries and regions with high physical and transition risk, are already outperforming the market.
Meanwhile, the regulators are also catching on. The American Society of Civil Engineers, Climate Disclosure Standards Board, Prudential Regulation Authority, the TCFD, and other bodies are swiftly moving from optional qualitative disclosures to mandatory quantitative disclosures. At the same time, activist shareholders are calling for a real accounting of climate risk. How will companies respond if investors announce at the annual general meeting that the balance sheet is flawed because it ignores physical and transition climate risk?
Whether it is the carrot or the stick that motivates us, climate risk is upon us. Calculating it should not be seen as impossible, or scary, or worrisome, or even burdensome. Climate risk may be a new type of risk, but it is just that: a new type of risk. It is no longer a black swan; it can be quantified and predicted. We have taken on new risks before. It’s now time to do it again.
Meghan Purdy is a Senior Product Manager at Jupiter Intelligence. Learn more about Jupiter at jupiterintel.com.
