Rüdiger Kiesel and Gerhard Stahl argue capital charges are not sufficient for insurers to manage climate risk, and propose an approach based on the fundamentals of risk management
Money makes the world go round
This contribution – an excerpt of our paper, A Prolegomenon of Managing Climate Risk – reviews current topical aspects of the discussion on the regulation of climate risks for insurance businesses from the methodological risk management perspective. Taking the necessity to manage climate risks for granted, our point of interest is on the implementation.
The starting point is the insight that climate risks are at the present time not adequately reflected in the prices of financial instruments.
Let us use two specific examples to support our point. First, the spread of a current Talanx green bond on an equivalent brown bond was only a few basis points. Second, a recent study by Blasberg, Kiesel and Taschini reveals that the order of climate risk in credit default swap spreads is less than 50% of the size of market risk for the European market and non-existent for the US markets.
A variety of academic studies and practitioners' reports document similar mis-pricings for e.g. bond, equity and real-estate markets.
Time and uncertainty is not climate-money (yet)
The time horizon of climate events and their associated causalities create epistemic and stochastic uncertainties.
Deep uncertainties (unknown unknowns and unknowable unknowns) are the dominant characteristics of climate risks. These deep uncertainties are mirrored in the uncertainties over how to price and to prioritise actions.
Thus, the tragedy of the horizon (Mark Carney's phrase to describe how we find it hard to manage far-off risks) has to be complemented by the tragedy of unknowable unknows.
The 'tragedy of the horizon' has to be complemented by the 'tragedy of unknowable unknows'
Value-at-risk is key, not value-at-uncertainty
From the 1990s, the metric of value-at-risk (VaR) has been central to risk-based supervision as well as decision-based risk quantification (enterprise risk management) in companies.
VaR perfectly links financial mathematics and risk management, and establishes the insight that adding cash – as a partial hedge – always transforms an unacceptable risk position to an acceptable one.
The deep uncertainty of climate risks makes this insight obsolete, implying the need for a risk management approach which is not based on capital buffers. Thus, mainstream approaches for modelling the relationship between economy and climate (such as proposed by William Nordhaus), which are based on a few well specified scenarios, fall short to serve as a starting point in generating meaningful strategies for an adequate risk management.
A blueprint from life insurers
During the prolonged era of low interest rates, life insurance companies – whose products featured long-term interest rate guarantees – faced significant challenges in terms of satisfying adequate solvency quotas as well as on the viability of their model of business.
Obviously capital is only of limited help in finding a solution strategy in this context. On the contrary, the granting of transition measures – which included a change of products and restructuring of asset portfolios – allowed life insurers to adjust to the changing financial environment and to ease capital requirements during that period.
Crucial to the success of the process was the continuous regulatory dialogue, which also served as a control measure. Thus the change from a capital-based to a resilience-based approach proved to be the key to success.
Another change management strategy based on resilience is the mitigation technique, which accounts for inherent uncertainties, but also establishes a coherent and viable framework. Time can be viewed as the capital of resilience: in the context of life insurance, it took 16 years.
Time can be viewed as the capital of resilience
How to manage climate risks, as you must
A forward-looking metric such as Implied Temperature Rise (ITR) can be used to implement a resilience-based approach in the context of climate risks.
An ITR metric estimates a global temperature rise associated with the carbon dioxide emissions of a single entity (company, region or country).
Given a temperature target, a carbon emission budget available to reach it with a given probability can be specified. The entity under consideration also should provide intermediate emission targets in line with its carbon budget to reach a given target.
As an ITR disclosure directly informs about the position of an entity in relation to its (and the global) climate target, it can be used to monitor the resilience of an entity. In particular, the time series of ITRs of the entity represents an indicator of the dynamics of climate risk of the entity in relation to the overall system.
Figure 1 illustrates the idea of a resilience-based climate risk management approach.
Figure 1: Expected Emissions on a Net-Zero Path
From the end point of the realised emissions (in blue) one can draw the expected path of emissions (in brown) according to the intermediate emission targets of the company.
Based on historical emission reduction, natural language processing (NLP) machine learning techniques applied to company communication, and expert opinion, a p%-confidence band can be estimated (shaded areas).
Based on this probabilistic model, emission paths (such as the green, yellow and orange ones) can be simulated. Thus, the approach allows regulators and investors to judge the likelihood of a company meeting its targets.
Rüdiger Kiesel is a professor at the University of Duisburg-Essen, where he leads the House of Energy Markets and Finance. Email: [email protected]
- Kiesel, R., Stahl, G. (2022): A Prolegomenon of Managing Climate Risk. Available on SSRN.
- Blasberg, A., Kiesel, R., Taschini, L. (2022): Carbon Default Swap – Disentangling the Exposure to Carbon Risk Through CDS. Available on SSRN.
- Hellmich, M., Kiesel, R. (2021): Carbon Finance – A Risk Management View, World Scientific Press.