By Jamie Selig, Political Consultant for the Economy and Financial Services & Jack Green-Morgan, Senior Political Consultant for Energy, Utilities and Net Zero.
Today, the Institute and Faculty of Actuaries and the University of Exeter have published a joint report which explores risk management in light of the intensifying impacts of climate change. In particular, the report suggests that using the concept of “planetary solvency” will guide a better-informed approach to risk management.
So, what is planetary solvency, how does it challenge the existing approach to risk management, and why should policymakers and businesses take notice?
What is Planetary Solvency?
The concept of planetary solvency demands that financial institutions recognise that the economy and society are fundamentally dependent on “Earth systems.” As such, societal development, prosperity, and the health of the economy should be recognised as being intertwined with progress on global climate goals.
Planetary solvency should be understood in much the same way as financial solvency. Whereas financial solvency assesses a firm’s ability to meet its financial obligations, planetary solvency assesses the Earth’s ability to meet our economic and societal needs in a sustainable way. As such, if a firm’s ability to service its debt falters, then the risk of ruin becomes a realistic proposition. If the Earth’s ability to service our basic economic and social needs begins to falter, the risk of ruin – i.e., planetary insolvency – becomes a realistic proposition.
By redefining solvency in planetary terms, the report aims to provide a framework for policymakers to understand that there is a real risk of ruin if they fail to properly consider and address the impacts of climate change.
As the report notes, climate risks have always been inherently hard to model. This provides a key problem for Government and firms in the era of net zero. More recently, firms have attempted to incorporate climate risks into their broader risk management frameworks. However, as the report notes, traditional climate risk assessment methodologies understate the most severe economic impacts of climate change.
The authors says that traditional risk management methodologies “typically focus on single risks in isolation, missing network effects and interconnections, underestimating cascading, compounding risks.” This phenomenon is compounded by the fact that a scientific approach has, thus far, underestimated the impacts of climate change currently being experienced globally.
To address this, the ‘planetary solvency’ risk management approach presented by the authors would require the exploration of plausible scenarios, rather than likely scenarios. This is particularly important when the potential consequences are existential and severe. In practice, this means that when it comes to addressing systemic climate risk, planetary solvency can be applied to estimate the likelihood and severity of the risk of ruin where conclusive data is not available. This, in turn, would allow for steps to be taken to manage risk in ways which consider the wider impacts of climate change and, therefore, respect the goal of maintaining planetary solvency.
Lessons for Decision-Makers
For those familiar with climate and sustainability policy, the report draws oft-repeated conclusions: that humanity relies on the “Earth system”, that climate change threatens the stability of that system, and that – without mitigation and adaptation – the severe impacts of climate change could lead to “severe societal upheaval”, with global consequences.
Where this report breaks new ground for those involved in assessing risk is through the explicit recognition that:
“Our dominant economic model doesn’t recognise a dependence on the Earth system, viewing climate and nature risks as externalities.”
This has major implications for risk management. In the past, failures to recognise systemic risks have been ruinous, but not final. However, the failure to recognise the risk of ruin in the scenario of intensifying climate impacts has resulted in a lack of urgency and action by policy makers.
The authors diagnose two possible reasons for the failure to recognise these systemic risks. Firstly, they may have occurred as a result of incomplete or imperfect knowledge. Secondly, they suggest climate risks may have been “badly communicated, with important messages lost in scientific detail” or, more cynically, that climate goals had fallen “victim to misaligned incentives such as short-term profit winning over long-term sustainability.”
The authors call for stronger governance structures and clearer, easy-to-digest risk assessments and other risk-related information to ensure well-informed decisions can be made. In addition, the authors suggest that the current focus on short-term economic concerns in risk management — to the exclusion of considerations about the wider “Earth system” — have led to much higher levels of risk being accepted.
These conclusions have major implications for the way policy makers and corporate decision-makers approach climate change. The idea that the current understanding of climate risk fails to appreciate knock-on effects or tipping points should be a cause for alarm. The report calls for greater heed to be paid to these compounding impacts, suggesting that a focus on isolated risks and their individual costs leads to an underestimation of the need for urgent action, and a failure to recognise how “individual disruptions or failures [can] cascade into a system-wide failure.”
This is crucial for decision-makers who wish to support a just and orderly net zero transition, either at an organisational or national level. Failure to appreciate the need for urgent action to address systemic risk will likely lead to insufficient or delayed mitigation and adaptation policies. This, in turn, could lead to a failure to prevent the worst impacts of climate change, their knock-on effects, and their societal consequences — with each impact and its consequent effects requiring ever greater resources to address it.
Net Zero Discourse
With this in mind, this report makes an important contribution to the political discourse on net zero and the response to the threats of climate change. For a long time, the mainstream response to concerns about the societal impacts of climate change was to suggest that societies would utilise the economic growth gained by carbon-intensive resource extraction and environmental degradation to invest in low-carbon assets and climate adaptation. In this way, society would become more prosperous, less emissions-intensive, and better equipped to deal with the impacts of climate change over time.
However, now, as this report suggests, emissions-intensive growth has taken humanity “beyond planetary boundaries”, with climate change impacts arriving quicker and with more intensity than forecast. The risks of continuing with the status quo, therefore, outweigh the benefits. Failure to act urgently and with due regard to the actual risks of climate change is likely to be more expensive in the long-run, as knock-on effects require increasing volumes of diminishing resources. This increasing resource requirement, in turn, erodes Governments’ and organisations’ ability to implement proactive mitigation or adaptation measures, exacerbating and compounding future climate impacts and leading to a spiral of negative consequences.
As the report outlines, actuaries are concerned with “minimis[ing] the risk of failure”; and the failure to appreciate the urgency of climate risks – and to act with sufficient speed – will likely leave countries and communities exposed to “societal upheaval.”
For those who see this as an issue for only the most climate-vulnerable countries, the report also makes clear that local crises could easily “spread [elsewhere] from vulnerable regions through our globalised socio-economic systems.”
Conclusion
As this report – building on others before it – has suggested, policymakers and corporate planners with a proper focus on a just and orderly transition would do well to embed a realistic assessment of the risks of climate change into their decision-making. By refocusing away from purely economic considerations to a focus on planetary solvency, policies and plans are more likely to adequately preserve the Earth system on which humanity depends.