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Business
Emma Ricketts

'It's going to be messy': Banks underestimate threat of climate change

It's easy to underestimate the extent of risks, says climate modelling expert Sandy Trust. "It’s like standing on the deck of the Titanic and looking backwards." Image: Willy Stoewer/Getty Images

Modelling the impact of rising temperatures is an 'ongoing and living exercise', banks acknowledge. But climate planning experts say they're being complacent.

The year is 2100. Global temperatures have increased by 4.4°C.

Thousands of people have abandoned their properties and moved inland, away from rising sea levels. Extreme weather events mean transport infrastructure is unreliable, and shipping routes to New Zealand are frequently disrupted. Rainfall on the West Coast has increased by 40 percent, while other drought-stricken parts of the country have limited stock numbers and crop sizes to conserve water.

This isn’t a dystopian reality from a young adult novel – this scene describes a plausible future if the world fails to reduce greenhouse gas emissions.

READ MORE:Big banks’ challengers find hope in Commerce Commission inquiryDavid Williams: Climate records put heat on politicians

The catastrophic scenario, known as the “hot house” scenario, has been adopted by the NZ Banking Association to help New Zealand-based financial institutions measure their exposure to climate-related risk and opportunities.

However, according to recent research, this sort of economic modelling frequently fails to align with scientists’ doomsday projections for the future. Half of the world’s population could be living in potentially-lethal temperatures by 2100. But scenarios consistently undervalue the likely financial impact of such a world, experts say.

New Zealand is not immune. Under the Banking Association’s Hot House scenario, domestic GDP would be only 2.7 percent less than its 2050 baseline scenario, which assumes no risk from climate change. To put that in context, that worst case Hot House scenario still has domestic GDP rising to NZ$475 billion, a 23 percent increase from today. The baseline scenario has GDP rising even more.

"It’s like standing on the deck of the Titanic on 14 April 1912 and looking backwards and saying, 'it’s been a pretty peaceful voyage so far, so things should be okay'." – Sandy Trust, UK Institute of Actuaries

Under the Banking Association’s Orderly scenario, decisive climate action would limit the world to 1.4°C temperature rise – and still has the potential to deliver a positive impact to domestic GDP.

"That is completely implausible," says Sandy Trust from EY, the author of a recent report by the UK Institute of Actuaries.

Compare the banks' worst case scenario with the one designed by the Intergovernmental Panel on Climate Change – one where the world continues to rely intensely on fossil fuels. In a world that assumes 4.4 degrees of warming by 2100, society would be facing an existential risk of collapse, Trust says.

Matt Raeburn, a New Zealand-based climate scenarios specialist with consulting firm WSP, also doesn’t think the banks' scenarios properly reflect the risk.

"To put it colloquially, when I read the NZ Banking Association’s scenarios, I just don’t think they get it yet," he says.

"They have really no concept of how disruptive any climate scenario will be – and there is no non-disruptive option. The orderly scenario, which is the best one, is still an incredibly disruptive, painful, expensive scenario, during which time many organisations will fail, possibly including some banks."

Stress testing banking

As we are confronted by the physical realities of climate change increasingly often, banks and entities across the financial sector face unprecedented risk to their assets.

Whether it’s mortgage portfolios that cover coastal properties vulnerable to sea level rise, or investment decisions in industries that could soon be replaced by lower-carbon alternatives, banks sit at the centre of the risks and opportunities associated with climate change.

Responding to the growing risk, the Government decided in 2020 to mandate disclosure of climate-related risk for 200 of New Zealand’s largest entities, including banks, credit unions, and building societies with assets that exceed $1 billion.

Scenario analysis is an integral part of this process. Essentially a 'what if?' exercise, it requires entities to assess their climate-related risk against future, possible scenarios.

"The Hot House scenario is already happening in parts of the world. For many people in our climate, the apocalypse has already happened." – Matt Raeburn, WSP

The Reserve Bank also relies on climate scenarios to “stress test” banks, a process that assesses their likely resilience in severe, but plausible, future situations.

Such risk modelling is not uncharted territory. Banks have long relied on scenarios to determine their level of risk – typically by using past data. For example, historic stock market returns give insight into the sort of economic volatility expected in the future.

But climate scenario modelling is unique. There is no historical precedent. Banks are required to assume several unknown factors, including the level of future emissions in each scenario, how quickly the climate will warm for a given level of emissions and the extent of damage expected.

This makes it easy to underestimate the extent of risks, Trust says. "It’s like standing on the deck of the Titanic on 14 April 1912 and looking backwards and saying, 'it’s been a pretty peaceful voyage so far, so things should be okay'."

To help banks carry out this analysis, the Banking Association developed three scenarios – Orderly, Too Little Too Late and Hot House – and released them in June.

"The NZ Banking Association climate scenario narratives will inform our scenarios. But it is important to note that scenario analysis is an ongoing and living exercise." –Tom Williams, Kiwibank

ANZ, ASB, BNZ, Westpac and Kiwibank have all affirmed their commitment to building on these. But they warn that we are currently in early stages. Data remains hard to come by and expertise is still developing.

"The NZ Banking Association climate scenario narratives will inform our scenarios,” says Kiwibank's head of sustainable finance, Tom Williams.

"But it is important to note that scenario analysis is an ongoing and living exercise. The NZ Banking Association climate scenario analysis will be further developed and refined, just as Kiwibank’s comprehensive scenarios will be."

The Reserve Bank released its climate stress test scenario this week.

Under this scenario, late policy action sees 2°C of warming by 2050. It envisages severe operational risk, such as damage to bank infrastructure from flooding, as well as two extreme, one-in-100-year inland flood events in Auckland over consecutive years and a one-in-100-year drought event spanning four years.

The impacts on GDP are compared to the worst years of the 2007-08 global financial crisis, albeit over a longer time period.

Underestimating the risks

The Banking Association’s scenarios were developed with reference to scientific pathways developed by the Intergovernmental Panel on Climate Change, as well as economic models produced by the Network for Greening the Financial System. The Reserve Bank also relied on the Network’s work.

But they exclude key factors in their analysis and they miss the point, Trust says.

The Network estimates only cover chronic risks like sustained higher temperatures or increased rainfall – not acute physical ones. So impacts related to extreme weather events, coastal inundation or the wider societal impacts from mass migration are excluded.

"Climate reporting entities’ ability to correctly assess the full future physical risk from climate change will improve as they both gain a better understanding of which global scenario/pathway that we are heading down and as they gain better modelling capability to understand the physical risks." – Miles Erwin, NZ Banking Association

"It isn’t the endpoint that is important,” Trust says. “We could argue all day about whether it will be four, five or six degrees and what GDP loss that will cause. But the key point is: at any level of warming, what sort of things will be happening? We need to focus on having consistency between the catastrophic events that the climate scientists are talking about and the economic modelling.”

In addition to underestimating risk, the scenarios are hedging, Raeburn says. By using non-committal language that things ‘may’ or ‘are likely to’ happen, it is impossible for banks to test their resilience against the circumstances.

But the reality is that it’s too difficult to assess the risks over long-term timeframes, Banking Association spokesperson Miles Erwin says. Instead, scenarios are used to try and illustrate a range of possible outcomes without necessarily providing the full picture.

"Climate reporting entities’ ability to correctly assess the full future physical risk from climate change will improve as they both gain a better understanding of which global scenario/pathway that we are heading down and as they gain better modelling capability to understand the physical risks that climate change creates within each scenario," he says.

"If the economic modelling says, ‘don’t worry, it won’t be that bad,’ while the science warns of an apocalypse … that could cause delays in action." – Sandy Trust, EY

However, these scenarios are not even close to realistic, according to Trust and Raeburn, who both point to the exclusion of tipping points. These points are thresholds which, once crossed, trigger irreversible changes to the climate – like the loss of the Amazon rainforest or the Greenland ice sheet. Once viewed as low-likelihood events, these are now seen to be high impact, high likelihood events.

"The Hot House scenario is already happening in parts of the world,” Raeburn says. “For many people in our climate, the apocalypse has already happened."

So far, New Zealand has fared better than other parts of the world, but when things worsen and we start seeing severe coastal inundation and unreliable supply routes, "it's going to be very, very, very expensive under any of those scenarios," he adds.

The impacts of failure

If players in the financial sector continue to underestimate the risks posed by climate change, even in the short term, the worst case scenario is losing all consistency between climate science and economic modelling, Trust says.

"If the economic modelling says, ‘don’t worry, it won’t be that bad,’ while the science warns of an apocalypse … that could cause delays in action," he explains.

For Raeburn, the stakes are even higher. “The worst case scenario is a complete failure of New Zealand's economy,” he says.

"It will be a bit of a reckoning for the banking sector and individuals in these organisations will start to understand the risks better. But until then, there aren’t enough people in the room trying to create scenario narratives that insist on the need for transformational change." – Matt Raeburn, WSP

Whether New Zealand has the financial capacity to cope with the physical impacts of climate change is an increasing concern, he adds, referring to the costs associated with catastrophic weather events like Cyclone Gabrielle. "It's going to get significantly worse, even under a 1.5°C Orderly scenario."

However, Raeburn thinks there is still time. As we approach 2030, it will become a lot clearer whether companies and organisations can feasibly meet their emissions reduction targets, he says.

Those that are not on track will likely face intense political and economic pressure to adjust their practices.

"It's going to be messy, but I think we will find out very soon who will actually be able to meet their targets," he explains.

"It will be a bit of a reckoning for the banking sector and individuals in these organisations will start to understand the risks better. But until then, there aren’t enough people in the room trying to create scenario narratives that insist on the need for transformational change."

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